WASHINGTON — Health savings accounts or HSAs are a hot topic these days, primarily because they provide tax advantages and savings options for those who invest in them. HSAs are also often misunderstood and — like other savings vehicles — come with rules and exceptions to those rules. Let’s take a closer look at how HSAs are changing how we think about paying for medical expenses now and in retirement.
The basics
Health savings accounts were first introduced in 2003 as a way to offer Americans additional tax advantages during their working years. They offer significant tax-savings opportunities because:
1. Contributions going in are tax-deductible
2. Savings in these accounts can be invested and grow tax-free
3. Withdrawals aren’t taxed when they are withdrawn so long as the funds are used for qualified medical expenses
As a result, HSAs are growing in popularity. Today, HSAs hold more than $40 billion in total assets and nearly three in 10 employees are covered through work-provided HSA plans. As insurance costs continue to rise and more companies opt for high-deductible health care plans, these accounts are becoming a more common component of a solid retirement plan.
The benefits
HSAs have several advantages over other forms of tax-advantaged savings. First, they are an improvement over Flexible Spending Accounts (FSAs) which don’t allow unused balances to carry over into future years. By contrast, more than three-quarters of HSA account holders withdraw less than they contribute each year. According to Fidelity, roughly a quarter of people with HSAs don’t use any money in their accounts in the year of contribution. That means they serve as additional savings accounts to support future spending needs.
Another advantage is that funds in an HSA account can be invested for growth. It effectively functions as a secondary form of retirement savings, especially for those in higher income brackets who may not qualify for Roth or regular IRA contributions due to income restrictions. Because an HSA provides tax-free compounding, investing the account balance can boost retirement savings, provided you’re able to cover current medical expenses from regular cash flow.
Investment choices within an HSA depend on the account custodian, but many offer solid options. And if you aren’t comfortable putting the entire amount at risk in the market, a good general rule is to hold enough cash in your HSA to cover expected near-term medical expenses and invest the remaining funds.
Many employers offer some form of matching contributions, so you’ll also want to be aware of the minimum HSA contribution that qualifies you for a company match to maximize your account contributions. Like other types of retirement savings accounts, an HSA is portable. If you change jobs or health insurers, your HSA comes with you.
The drawbacks
One of the main drawbacks of the HSA account structure is that you must have a qualifying “high deductible health insurance plan.” That means your family health insurance plan is required to have a minimum annual deductible of at least $2,600 and a maximum annual deductible including other out-of-pocket expenses of $13,100. If you have an individual plan, you qualify for an HSA if your minimum annual deductible is at least $1,300 and your maximum annual out of pocket expenses is $6,550. Note that in order to qualify, you generally cannot be covered by other health insurance that is not a high deductible plan. For example, you would not qualify for an HSA if you’re included on a spouse’s family policy, or if your spouse has a regular flexible spending account.
While an HSA has no income limits to participate, it does have contribution limits. For 2017, you can contribute up to $6,750 if you have family health care coverage, or $3,400 for individual coverage. Much like the IRA catch up contribution provisions, if you are 55-years-old or older, you’re allowed an additional $1,000 catch up contribution for either family or individual plans.
Once you reach age 65, you may not be eligible to contribute to an HSA. If you enroll in Medicare — since Medicare is not a high deductible health insurance plan — you lose your eligibility to make HSA contributions. Similarly, if you claim Social Security at age 65 or older, you are automatically enrolled in Medicare Part A, which disqualifies you for HSA contributions.
HSA rules become even more complicated for those who claim Social Security later than full retirement age or for employees who keep working after age 65. All this means it’s important to have a thoughtful strategy for your HSA contributions and a withdrawal strategy as you approach your mid-60s.
Lastly, because HSA accounts are tax-advantaged, they have whopping penalties (20 percent) if you are under age 65 and withdraw funds for anything other than qualified medical expenditures.
Common Uses
HSAs provide tax benefits in exchange for using the account to pay for qualified medical expenses. Therefore, it’s important to understand which expenses qualify for reimbursement. The general rule is that any medical expense that qualifies as an expense deduction on your tax return qualifies for payment from an HSA. For a complete list, you can consult the IRA publication.
Some of the more common uses for HSA funds include Medicare premiums (Parts A, B, C and D, but not Medigap), co-pays on prescription drugs, dental work, hearing aids, COBRA premiums and home modifications made for medical purposes. While medical insurance premium payments are not qualified HSA expenses, there is an exception for long-term care (LTC) insurance premiums. The allowable amount for LTC costs is limited based on age. For example, for someone aged 51-60, the maximum LTC premium expense allowed is $1,530, whereas someone 60-years-old or older could pay up to $4,090 in LTC premiums from an HSA.
Why you shouldn’t be too quick to use HSA funds
Two key HSA advantages — tax deferred growth and tax-free withdrawals — lose their impact if you dip into your account too soon. That’s why we most often recommend that anyone 65-years-old or younger:
• Maximize HSA contributions for as long as possible
• Invest the funds
• Avoid using the account until they are at least 65-years-old or in retirement
Fortunately, once you turn 65, distributions from an HSA are no longer subject to penalty, so your use of funds no longer matters. However, distributions would be subject to income taxes if used for something other than qualified medical expenses. Generally, a solid planning strategy is to build up the HSA for use in retirement when medical costs are generally higher, and when other sources of retirement income would result in additional taxable income.
Some special circumstances
For divorcees, HSA planning may be a bit more complicated both for contributions and distributions. Generally, if you hold a family health insurance contract (i.e. one that includes you and your children), you can contribute to an HSA up to the family maximum, even if your ex-spouse is not HSA-eligible. If you are both HSA-eligible, the rules are less clear, so you’ll want to discuss your specific situation with your legal or tax counsel.
If there are HSA assets at the time of divorce, the account values should be included as assets in your divorce settlement. Much like transfers of IRA assets in divorce, HSA accounts can be split and transferred tax-free when ordered by a court. Proper handling of HSA assets in a divorce is also important because an ex-spouse’s medical expenses, even if they are qualifying medical costs, cannot be covered from the other’s HSA once the court orders separate maintenance. Paying ex-spouse costs out of your HSA subjects you to tax on the distribution, as well as the 20 percent penalty, if you are under age 65.
If you have college students on high deductible health care plans, note that they cannot make an HSA contribution so long as they are claimed as a dependent on their parent’s tax return. If parents are divorced, then either parent can pay their children’s eligible expenses tax free from their HSA, regardless of which parent claims the children as a tax dependents.
Future changes
Like retirement accounts, HSA account rules change annually, and contributions limits are subject to revision. In 2018, the savings opportunity increases to $3,450 for single coverage and $6,900 for a family. Given the current debate in our legislature about proposed changes in our tax law, both contribution limits and use of HSA accounts may be modified in the weeks and months ahead. Perhaps this gives us more reasons to maximize contributions in every year possible and to save and invest our HSA accounts for use in later years.
Dawn Doebler is a senior wealth adviser at Bridgewater Wealth and co-founder of Her Wealth®.
