Must-Know Facts About Health Savings Account
By Echo Huang, CFA, CFP®, CPA
A Health Savings Account (HSA) can be a powerful tool to help you save and invest, now, to pay for your qualified medical expenses (QMEs) during retirement. The HSA has become popular as more and more employers move to high deductible health plans (HDHP) in order to reduce insurance premiums. Employees must choose the HDHPs instead of traditional health insurance plans if they want to use their HSAs to fill the gap. I have used HSAs personally for about 10 years and I want to share these essential facts with you:
- The HSA provides triple tax benefits. Contributions are made with pre-tax dollars (free of federal, state and FICA taxes) through payroll if your employer offers it. If you purchase an HDHP on your own in the insurance market, you can set up your own HSA online and make contributions before the tax return filing deadline. You can choose to invest the balance and the growth is tax-deferred. Distributions are income-tax free if you use them to pay for qualified medical expenses (QME). "Typical" retiree expenses on health care are often as high as $500/month (or $1,000/month for a married couple), much of which are HSA-eligible QMEs, including Medicare premiums and out-of-pocket medical costs (although Medigap coverage doesn't count).
- How much can I contribute per year? For a self-only HDHP, you can contribute up to $3,400 in 2018 ($3,500 in 2019). For a family HDHP, you can contribute up to $6,900 in 2018 ($7,000 in 2019). If you are age 55 and older, you can contribute additional $1,000.
- The HSA balance does not expire, unlike the Flexible Spending Account (FSA). You don't have to spend the balance within the calendar year. You can keep the receipts of QMEs and get reimbursed from your HSAs many years from now as long as the expenses have not been reported as medical expenses on tax returns and increased your total itemized deductions. If your income is not low, it is difficult to get tax benefits through reporting medical expenses on Schedule A because total QMEs for the calendar year must exceed 7.5% of adjusted gross income (AGI) to generate tax benefits. Beginning in January 1, 2019, the 7.5% of AGI will increase to 10% of AGI. If your AGI is $100,000, you must incur greater than $10,000 QMEs in one year to be worth it to report them on Schedule A. Therefore, if you don't get tax benefits from your tax returns, then you can save the receipts and file them in a folder called "To Be Reimbursed from My HSA" - you decide the timing of distributions in the future.
I recommend that clients set aside extra cash in their savings account to pay for non-deductible medical expenses instead of taking distributions immediately from their HSAs so that the HSA balance can be invested for growth - treating this account as the tax free bucket for inevitable higher medical expenses during retirement. A health plan's actual annual deductible could be as high as $6,750 for an individual and $13,500 for a family, therefore you should increase your emergency savings to have enough to cover the annual deductible.
- The HSA can be more beneficial than a 401(k) to maximize wealth accumulation. Pre-tax 401(k) plan's distributions will be taxable, and a Roth 401(k) requires using after-tax dollars to fund it in order to have tax-free distributions. The HSA balance, on the other hand, can be distributed before age 59.5 without paying taxes and penalties.
In addition, it can even be more beneficial than some 401(k) plans with matching employer contributions. For example, if employer matching is 25% of your contributions to your 401(k) plan, your future income tax rate must be lower than 25% in order to surpass the contributions to your HSA. If your future tax rate is projected to be 40%, then $1.25 to your 401(k) plan equals to $0.75 after paying 40% future income tax, which is 25% lower than the $1.00 going to the HSA.
- Coordinate with your spouse to avoid excess contributions. If you and your spouse are both under age 55 and each have your own HDHP, then you must coordinate so as not to exceed the maximum contributions for a family as set by IRS. For example, let’s say you have a self-only plan and you can contribute $3,500. Your spouse and daughter have a family plan and a separate HSA account and if your spouse contributes the maximum for a family plan, $7,000 in her account, then the total contributions of $10,500 for your family exceed the IRS maximum of $7,000 in 2019. If you and your spouse are both age 55, then the total contributions under family coverage cannot be more than $9,000. You and your spouse must make the additional contributions of $1,000 to your or her own HSA.
If your employer contributes $500 to your HSA, then this amount reduces the maximum you can contribute to your HSA.
- Excess contributions aren't deductible. Generally, you must pay a 6% excise tax on excess contributions unless you withdraw the excess contributions by the due date, including extensions, of your tax return for the year the contributions were made.
- What happens at the death of HSA holder? If the spouse of the HSA Holder is the designated beneficiary, then the spouse can own this account balance and continue it as HSA account. If spouse isn't the designated beneficiary, the account stops being an HSA, and the fair market value of the HSA becomes taxable to the beneficiary in the year in which the holder dies.
Fidelity's annual "Health Care Cost Estimate" study for retirees estimates that a 65-year-old couple will need $245,000 to cover health care expenses in retirement. Think of your retirement savings (IRAs and 401k) as going to other retirement expenses such as food, shelter and clothes, and you can see that you need to jump-start saving in your HSA for your health care costs. You may have a few goals competing for your resources. The following is my proposed ranking of wealth-maximizing actions for investing and paying down debts:
- Contribute the maximum to an HSA (if eligible) and contribute enough to a 401(k) plan to get the maximum employer match.
- Pay down high-interest-rate debt. If the interest rate is greater than 6%, pay down the debt soon as investing may not generate a 6% annualized return over the short-term and you don't control the sequence of returns in stock markets.
- If you can save more, contribute to a College Savings 529 Plan, if it produces state income tax savings and if funding the future higher education costs of a loved one is important. Minnesota residents can start deducting up to $3,000 of 529 plan contributions per year, regardless which state's 529 plan you use.
- If you can still save more, then contribute the maximum allowed for the year to unmatched retirement accounts (401k, IRA or Roth IRA).
To summarize, health care costs in the U.S. are increasing, and you should devote some time to comparing health insurance plans including HDHPs. Work with your health care professional and your financial advisor to analyze your health and tax situation to make the best decisions for you and your family.