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What You Need to Know About Health Savings Accounts (HSAs)

October 28, 2020

Open enrollment season is quickly approaching, and I want to make sure you take full advantage of all that's available to you, especially a Health Savings Account (HSA). The HSA is a powerful tool to help you save and invest in paying for your qualified medical expenses (QMEs) now and into retirement. It's become popular as more employers move to high deductible health plans (HDHP) to reduce insurance premiums. A critical note about an HSA is that you must choose an HDHP instead of traditional (lower deductible) health insurance plans if you wish to make contributions to an HSA. 

Six Essential HSA Facts

I have used HSAs for 10+ years and find them to be very beneficial. Here are a few essential facts I'd like to share with you:

1.    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 how to invest the balance, and the growth is tax-deferred. Distributions are income-tax-free if they are used 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 is HSA-eligible QMEs, including Medicare premiums and out-of-pocket medical costs (although Medigap coverage doesn't count). 

Once enrolled in Medicare, you can no longer contribute to an HSA. But you can take distributions from your HSA for QME.

2.    How much can I contribute per year? The annual limit on HSA contributions for 2021 will be $3,600 for self-only and $7,200 for family coverage, which is about a 1.5 percent increase from the 2020 limits. This represents an increase of $50 for self-only coverage and $100 for family coverage compared to 2020. 

3.    Unlike the Flexible Spending Account (FSA), the HSA balance does not expire. This feature is a crucial difference between the HSA and the FSA. The FSA balance (also funded by your pre-tax dollars and your employer) must be spent by the end of your plan year, while funds contributed to the HSA can be invested and grow for many years to come.

In fact, 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 inevitably higher medical expenses during retirement.

One other exciting difference between the HSA and the FSA is that, with the HSA, you can save your QME receipts, and, as long as you've not included them on your tax return as part of your itemized medical deductions, you can choose to get reimbursed for those expenses in the future.

4.    The HSA can be more beneficial than a 401(k) to maximize wealth accumulation. Consider this: Pre-tax 401(k) plan distributions will be taxable in the future, and a Roth 401(k) requires using after-tax dollars to fund it to have tax-free distributions. On the other hand, the HSA balance—funded with pre-tax dollars and distributed tax-free—can be distributed before age 59½ 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 your employer matching is 25% of 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. Additionally, if your future tax rate is projected to be 40%, then $1.25 to your 401(k) plan equals $0.75 after paying 40% future income tax, which is 25% lower than the $1.00 going to the HSA. Clearly, the HSA had significant advantages.

5.    Coordinate with your spouse to avoid excess contributions. If you and your spouse each have your own HDHP, then it's critical you coordinate your contributions, so your total in one tax year does not exceed the maximum contributions for a family as set by the IRS.

Also, be sure to account for any employer contributions in the overall contribution total. If your employer contributes $500 to your HSA, then this amount reduces the maximum you can contribute to your HSA. 

If you happen to contribute too much, you can withdraw the excess contributions by your tax return filing due date, including extensions. Otherwise, you will pay a 6% excise tax on excess contributions.

6.    What happens to your HSA upon your death? The answer here depends on who the beneficiary is. If your spouse is the designated beneficiary, then he or she can own this account balance, and it continues as an HSA account. Suppose the designated beneficiary is someone other than your spouse. In that case, the account stops being an HSA, and the fair market value of the account becomes taxable to the beneficiary in the year you die. If your estate is the beneficiary, the account's value is included in your financial income tax return. 

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