Health Savings Accounts (HSAs)

Published On: November 24, 2020

Written by: Ben Atwater and Matt Malick

Last week, amid continuing election uncertainty and the massive coronavirus spike, we wrote you about the general healthcare planning environment.  Today, we are going to sharpen our focus and investigate Health Savings Accounts (HSAs), an increasingly popular way of preparing for retirement and saving for healthcare expenses. 

HSAs are another way to defer dollars and lower your annual tax bill if you enroll in an HSA-qualified high-deductible health insurance plan (HDHP).  But unlike with a 401(k) or an IRA, if you withdraw funds from an HSA for qualifying healthcare expenses, you avoid taxes altogether, forever. 

If you are self-employed, an HDHP may be worth exploring.  If you are an employee and your employer offers an HSA plan, maximizing contributions is wise. 

HSA Overview

• A tax-favored savings account you use in conjunction with a high-deductible health insurance plan
• Contributions to the HSA are tax-deductible up to the legal limit ($3,600 for an individual plan, $7,200 for a family plan and $1,000 for an age 55+ catch-up in 2021)
• The IRS does not tax withdrawals you use to pay for qualified expenses
• Your earnings and appreciation accumulate on a tax-deferred basis; if you use your funds to pay for qualified expenses, you are never taxed
• Your unused money at the end of the year is not forfeited but allowed to continue growing tax-deferred for your lifetime
• The IRS taxes money you use for non-qualified expenses at your ordinary income tax rate with an additional 20% penalty if you are under age 65

We often recommend using an HSA as a “second 401(k).”  Since contributions are tax-deductible and HSAs are tax-sheltered as they grow, savers can often build up HSAs throughout their careers, particularly if their annual HSA contributions routinely exceed their out-of-pocket healthcare expenses or if they earn enough to pay for healthcare expenses with after-tax wages. 

You must verify that your healthcare plan is HSA-qualified before opening an HSA account. If you are self-employed, talk with your insurance carrier.  If you work for an organization, check with your human resources department.

Some HSA accounts only function like bank savings accounts, but more and more plans offer investment options.  Investment options differ widely depending on the account custodian.  Some institutions may offer a handful of mutual funds that they themselves manage.  Other custodians have a much wider selection, such as Fidelity and Schwab with virtually unlimited options.  The key to using your HSA as a “second 401(k)” is having decent long-term investment options. 

An estimated 95% of HSA owners hold their accounts in cash or money market funds because their balances are small, and they plan to use them for short-term medical expenses.  Higher earners, however, should fund medical expenses during their working years with after-tax compensation.  Avoiding withdrawals from your HSA during your working years and aggressively investing your HSA may help adequately prepare for healthcare expenses in retirement, not to mention being highly tax favorable. 

HSA Plans and Medicare

Individuals are no longer permitted to contribute to HSAs once they enroll in Medicare (starting the first month of enrollment, enacting a pro-rated contribution limit for the year).

However, the funds already within the account may still be used as before, remaining tax-exempt if used for qualified medical expenses. Medicare Part A, B, C (Medicare Advantage Plans) and D premiums for account holders or eligible dependents over 65 are eligible for tax-exempt reimbursement (premiums are often taken directly from Social Security payments).

However, premiums for Medicare supplemental insurance (Medigap) are not eligible for tax-exempt payments or reimbursements.  So, if you have a large HSA account at retirement, it might pay to shop for a Medicare Advantage Plan rather than a supplemental plan. 

Qualified Expenses

In addition to certain Medicare premiums, here is a sampling of items that are also qualified distributions from your HSA: 

• Hospital bills and lab tests
• Surgery
• Ambulance services
• Eyeglasses
• Prescription drugs
• Alternative therapies (e.g. Acupuncture)
• Dental care
• Premiums for continuation of coverage plans (e.g. COBRA), health insurance while you are receiving unemployment compensation, qualified long-term care insurance (age-based limits apply) and Medicare (see above)

For a full list, refer to IRS Publication 502: http://www.irs.gov/publications/p502/

Items not included on the list may still qualify if they fall under the IRS description of a medical expense: “Medical expenses are the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body.  These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners.  They include the costs of equipment, supplies and diagnostic devices needed for these purposes.”

Non-Qualified Expenses

As with the qualified medical expenses, a more detailed list of non-qualified expenses can be found in the link above, but here is a sampling:

• Regular health insurance premiums
• Surgery for purely cosmetic reasons
• Health club dues
• Maternity clothes
• Vitamins and dietary supplements

Contributing to an HSA

Many HSA accounts allow users to make contributions online and many employers facilitate automated payroll deductions.  The HSA contribution limits for 2020 are $3,550 for an individual or $7,100 for a family, while taxpayers age 55 and over can make an additional $1,000 catch-up contribution.  For 2021 the IRS has increased the limits to $3,600 and $7,200 for individuals and families, respectively, while the catch-up remains $1,000. 

How to Pay Qualified Expenses

The custodian of your HSA will typically issue you a debit card and / or checks, allowing you to use HSA funds at the point of sale.  Additionally, custodians should allow you to reimburse yourself for qualified expenses through electronic transfers. 

Other Information

• If you switch to an insurance plan that is not HSA-qualified, you will not be able to contribute further to your HSA account, but you still have access to and control over the funds.  Other than a prohibition on contributing, the same rules apply. 
• The HSA custodian will issue tax form 1099-SA every year to account holders, reporting all distributions taken from your account. You must file Form 8889 with your tax return to report your distributions. We recommend keeping all receipts for qualified medical expenses in case the IRS audits you.  Your qualified withdrawals must occur in the same calendar year as the corresponding expense. 
• At death, you can designate your spouse as your HSA beneficiary, and it will then simply become your spouse’s HSA with all the same benefits.  Otherwise, you can designate your HSA to a non-spouse beneficiary and the proceeds will be taxable to them in the year of receipt (the same would be true if you left your HSA to your estate).  Your heirs, however, can use your HSA to pay your final medical expenses up to 12 months after your death.

HSAs remain a missed opportunity for many.  Vanguard data says that only 50% of those with an HSA contribute to it, only 14% contribute the maximum statutory amount and only 5% of HSA owners hold assets other than cash.  Remember, if you are in the financial position to pay your healthcare bills from after-tax compensation, the most important planning opportunity with an HSA is to utilize it as “a second 401(k).”  This should be a goal for many mass affluent households.