By Dan Federman, CFP®
According to the U.S. Department of the Treasury,1 “Health Savings Accounts (HSAs) were created in 2003 so that individuals covered by high-deductible health plans could receive tax-preferred treatment of money saved for medical expenses.”
To contribute to an HSA, the IRS requires you to meet the following requirements2:
- You are covered under a high-deductible health plan (HDHP) on the first day of the month.
- You have no other health coverage (excluding vision, dental, disability, accident, or long-term care) and are not covered by another plan (i.e., spouse’s employer plan).
- You aren’t enrolled in Medicare.
- You aren’t claimed as a dependent on someone else’s tax return.
How Much Can I Contribute?
The IRS sets the contribution limits for HSAs. In 2019, the annual limit on deductions for an individual with self-only coverage under a high-deductible health plan is $3,500 ($3,550 in 2020), and it is $7,000 ($7,100 in 2020) for an individual with family coverage.3
According to the IRS, a “high-deductible health plan” is a health plan with an annual deductible that is not less than $1,350 ($1,400 in 2020) for self-only coverage or $2,700 ($2,800 in 2020) for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $6,750 ($6,900 in 2020) for self-only coverage or $13,500 ($13,800 in 2020) for family coverage.
What Are Some of the Advantages of HSAs?
- Contributions are tax-deductible, meaning you don’t pay taxes on the money you put in the HSA.
- Some employers contribute to HSAs.
- You can make “catch-up” contributions of $1,000 if you are age 55 or older up to age 65.
- You can use your HSA to pay deductible expenses and co-pays.
- Unlike a flexible spending account (FSA), any unused money stays in the account from year to year.
- You can invest the savings in stocks, bonds, exchange-traded funds (ETFs), mutual funds, or an interest-bearing account, with tax-free growth.
- Distributions are tax-free when used for qualified medical expenses.4
- HSAs can be used to pay premiums for Medicare premiums.
- HSAs can be used to pay for long-term-care insurance (subject to IRS limits5).
- HSAs are not counted as an asset toward financial aid eligibility, nor would distributions count as untaxed income when they are used for qualified medical expenses.6
- After age 65, HSAs act like traditional IRAs and can be used as a source of retirement income. You will pay income taxes on distributions used for non-medical expenses but not a 20% penalty.
- HSAs can serve as a “tax-free IRA” if planned properly. By paying medical bills out of pocket and keeping detailed records of receipts, your HSA account can grow substantially over time. Later in life, you can submit claims to be reimbursed from your stash of tax-free savings. This, of course, comes with the caveat that you would need to have a long period of excellent health and excess cash flow.
What Else Should I Be Aware of When It Comes to HSAs?
Most people fund their HSA account through payroll deductions. However, one other option, as a one-time deal, is to fund your HSA account from an IRA through a “direct rollover.” This option allows you to make a qualified distribution from your IRA or Inherited IRA to the health savings account. If you roll over from an Inherited IRA, it counts toward the required minimum distribution (RMD) for the year.
Transferring from an IRA to an HSA converts the funds from tax-deferred status to tax-free as long as the funds are used for qualified medical expenses. But keep in mind that the amount rolled into the HSA from the IRA cannot exceed the contribution limit for the year.
Getting sick is unpredictable, making it potentially difficult to plan and budget for health care expenses. If you know you have a lot of health issues or expect high medical expenses in the next year, a high-deductible health plan may not be the right medical plan for you.
An HSA is intended for only medical expenses. If you spend HSA funds on non-medical expenses, the distribution will count toward income, and you will be penalized 20%. Only after age 65 will this 20% penalty disappear if used for non-medical expenses.
Our preferred way to use the HSA is to fund it each year while paying deductibles and other costs out of pocket. If you are fortunate to be in good health and have excess cash flow, an HSA is an excellent way to build up tax-free savings that can be used to pay for medical costs in retirement and supplement retirement income.
Schedule a complimentary meeting with a wealth advisor to discuss your personal situation.
Disclaimer: This is not intended to be tax advice. Always consult your CPA before taking any action that has tax implications.
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