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