For those not familiar with Health Saving Accounts (HSA’s), they are tax- advantaged accounts that Congress authorized in 2004. HSA’s are available to those who enroll in “High Deductible” health insurance plans. Employee contributions made to HSA’s are made on a pre-tax basis (or are tax deductible for those on individual health insurance plans not provided by an employer). Unlike the dollars in Flexible Spending Accounts, the amounts in an HSA can carry over into future years. If withdrawals from an HSA are used for approved medical expenses, the withdrawals are not taxed.
A high deductible plan is generally defined as having an individual deductible of at least $1,250 or a family deductible of at least $2,500. The maximum contribution that can be made during a single year is $3,250 for an individual and $6,450 for a family. You can make HSA contributions up until the time you enroll in Medicare (generally at age 65) and you can continue to draw down and spend any amounts in your account for health care expense past that date. Most employers now offer a high deductible option and a significant percentage of the plans in the individual (i.e. Obamacare) or small business markets qualify as high deductible. You are also allowed a once in a lifetime rollover from a traditional IRA to an HSA for the maximum annual contribution. You can roll over from a Roth IRA as well but that would be less advantageous since Roth contributions consist of post-tax contributions.
Congress introduced HSA’s to create an incentive for people to opt for high deductible health plans with the rationale that the high out-of-pocket deductibles would cause people to be more cost-conscious when obtaining care. HSA’s are steadily gaining in popularity. Recent studies indicate that the number of people in the US with HSA accounts in 2013 was approximately 15 million. Although the number of HSA’s is on the rise, less than 10% of the 200 million people covered under private insurance plans choose to open an HSA account.
Perhaps health care consumers fear that managing an HSA will involve a lot of paperwork or hassle. But a debit card is typically provided so there is no paperwork to worry about. My family has been using an HSA for four years, and I recall only once having to submit a receipt and that was due to an error on my part. Participants just need to keep track of the amount available in the account so you don’t “overdraw.”
Some health care consumers probably don’t realize that HSA’s are a truly tax-free investment. From an investment standpoint HSA’s operate just like IRA’s. HSA’s are typically provided by banks, and investors can allocate their funds into stocks, bonds, mutual funds and money market funds. The big difference versus an IRA is that, assuming HSA funds are used to pay medical expenses, withdrawals are tax-free. With a traditional IRA (or 401K, 403B etc.), you pay income tax on any withdrawals.
Assuming your cash flow allows for it, you should max out your annual contribution to an HSA. Whatever amount is left over in your HSA after paying current year medical expense can be invested in a diversified portfolio of mutual funds that aligns with your overall investment portfolio objective. In addition to covering ongoing medical expenses, HSA funds can be used to pay for expenses such as COBRA premiums, Long Term Care premiums and actual long term care expenses. Given this flexibility, there is little chance that the funds won’t be needed for qualified medical expenses at some point. If you still have a balance in an HSA at death and you transfer the HSA to a spouse it becomes the spouse’s HSA. However, if it transfers to anyone other than a spouse is no longer considered an HSA and withdrawals will be taxed as if it were a traditional IRA.
Another opportunity to consider is a one-time transfer from an IRA to an HSA. This option is especially helpful for those in a job transition who are trying to carefully manage their cash flow. The transfer essentially allows you to draw down some of your retirement funds without paying any taxes or penalties to fund current year’s health care expenses. Even if you are not cash flow constrained, taking advantage of this option and investing the funds allows you to move funds from a tax-deferred IRA to a tax-free HSA.
It can be challenging to find an HSA that allows you to invest in mutual funds with low fees. Because this is a small market without a great deal of competition most of the mutual fund offerings are high-cost, actively-managed funds that generate fee income for the banks sponsoring the HSA. But if you do some digging, there are a couple of low-cost options out there for those with plans in the individual or small business markets (i.e Obamacare). In employer-sponsored plans, your choice of HSA providers will probably be limited.
Feel free to reach out to me if you have any questions about HSA’s.