Significant changes could be coming to the health care landscape in the United States now that Republicans are in control of Congress and the White House—and one element that seems common to all the proposals being considered is an increased emphasis on HSAs or Health Savings Accounts. HSAs provide significant tax benefits and are used to pay for out-of-pocket medical expenses such as deductibles and co-pays; they also and can also be used as a supplementary retirement investment vehicle.
Most people are aware that HSAs are used for medical expenses and I will walk through the detail on how these accounts work, but what many are not aware of is that HSAs can also be valuable retirement investment vehicles. The reason is twofold. First is that funds contributed to an HSA and not used in the current year can be carried forward indefinitely. This differs from Flexible Spending Accounts (FSAs), another type of account used for medical expenses, where any unused balance at the end of the year is forfeited.
The second reason is the tax benefit. Contributions to an HSA are not taxed in the year made like a traditional IRA or 401K contribution. But unlike IRAs or 401Ks, withdrawals from HSAs are not taxed if used for qualified medical expenses. HSAs are the only investment vehicle I am aware of that is not taxed at all. I generally recommend to clients that they fully fund an HSA if possible, even if that means prioritizing ahead of IRA or 401K contributions (assuming any company match has been maximized). The portion of the funds contributed not needed for current year expenses can be invested and then used to pay for medical expenses that will be incurred well into the future, such as Medicare premiums or long-term care expenses. Plus, there is no penalty for withdrawing the funds for nonmedical expenses after age 65. You just pay the income tax as you would with an IRA withdrawal.
Congress authorized HSAs in 2004, and they are made available to those who enroll in qualified “high deductible” health insurance plans. The intention was to incentivize people to move to high deductible health plans, which would then make people more cost-conscious when obtaining health care. Many employers now offer an HSA-eligible option and qualified plans are available through the ACA (i.e., Obamacare) or small business markets. The way to know that a plan is HSA eligible is that HSA will generally be somewhere in the name of the plan. This is the case on the ACA exchange. If it is an employer-sponsored plan you may need to ask someone in the benefits department.
For 2017 the maximum contribution that can be made for the year is $3,400 for an individual and $6,750 for a family. If you are age 55 or older you are allowed an additional $1,000 catch-up contribution. If you are enrolled in a qualified high deductible plan for only part of the year, you may be limited to a prorated contribution.
The recordkeeping requirements of HSAs are less onerous than those of FSAs. To be reimbursed, you do not need to submit receipts, but you do need to keep record of the expenses in the event the IRS audits you. Plus, most HSAs issue debit cards, which are a convenient way to pay for your medical expenses.
Most HSA providers allow you to have two accounts: a cash account to be used for current year medical expenses and a brokerage account to invest any excess. In the brokerage account, you can invest in stocks, bonds, or mutual funds, just as you would in an IRA.
You are also allowed a once-in-a-lifetime rollover from a traditional IRA to an HSA for the maximum annual contribution. This option is especially helpful for those in a job transition who are trying to carefully manage their cash flow. The transfer allows you to draw down some of your retirement funds to fund current-year health care expenses without paying taxes or penalties. 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.
Like IRAs, HSA accounts can be rolled over to a different provider. When I left Best Buy in 2013 I rolled over my account to a provider that allowed access to low cost index funds. Unfortunately, many employer-sponsored plans force you to use the bank they have negotiated with, which may only offer high-fee mutual fund options. You will not be able to do a rollover until after you leave the company. Those signing up on the individual or small market exchanges have a lot more flexibility.
Those of you reading this who live in my home state of New Jersey should note that New Jersey is one of only three states (Alabama and California are the others) where HSA contributions are not tax deductible. However, you can deduct expenses paid with an HSA on your New Jersey return. In reviewing the past returns of my tax clients, I have noticed that accounting correctly for the tax impact of HSAs is one area that seems to be particularly error prone.
Feel free to reach out if you have any questions.