There’s a savings/investment account available to most working people that offers tax-advantaged contributions to be used for future medical expenses or retirement, or both. Think of an IRA, a ROTH, and an FSA (Flexible Spending Account) all in one. It is an HSA, or Health Savings Account. I first wrote about HSA’s in 2017. They were good then and are great now. For the most part, advantageous tax benefits and multi-purpose uses come with an HAS, but the bad news is, not everyone is allowed to contribute to one. The primary requirement for an HSA is a qualifying high-deductible health plan (HDHP). The IRS definition of this term changes annually. For 2020 it refers to a health insurance plan with a deductible of at least $1,400 for self-only coverage or $2,800 for family coverage.
What is an HSA?
An HSA is a type of savings account that allows you to set aside money on a pre-tax basis to pay for qualified medical expenses. I mentioned above the requirement that you have a “high deductible health plan” (HDHP). High deductible plans usually have lower monthly premiums than plans with lower deductibles. By using the untaxed funds in an HSA to pay for expenses before you reach your deductible and other out-of-pocket costs like copayments, you reduce your overall health care cost. Contributions to an HSA can have a meaningful tax impact. HSA contributions are an above-the-line deduction on a tax return (similar to an IRA contribution). For 2019, Americans can still fund $3,500 for individual plans and $7,000 into family plans. Further, if you are over 55, you can also do a “catch-up” contribution of $1,000. For many, this can translate into real tax savings. You have up to the tax deadline of April 15, 2020 for a 2019 tax-year benefit. Consider contributions to HSAs as important as your 401K and IRA savings. The HSA contribution limits are set annually by the IRS; for 2020, they’re $3,550 for an individual and $7,100 for a family. In addition to these limits, HSA participants who are 55 or older can contribute an additional $1,000 as a catch-up contribution. So, if you’re at least 55 years old and have self-only health coverage, you can contribute a total of $4,550 to your HSA in 2020. If you’re 55 or older and are the primary insured on a qualifying family health plan, you can contribute as much as $8,100 to your account. Here’s an important note on your contributions: If your employer makes HSA contributions to your account on your behalf, it’s important to realize that these are included toward your annual limit. When my ERPE Excerpts featured an article on HSAs in 2017, the contribution limits were $3400 for an individual and $6750 was the family limit. Since then, there have been efforts to dramatically increase these contribution limits, including a bill that passed the House of Representatives in 2018 that would have roughly doubled them. However, no new laws governing HSA contribution limits have passed.
HSA Tax Benefits
When I call HSAs tax-advantaged accounts, I mean HSAs are tax-advantaged accounts! I’m talking tax-deductible, tax -deferral AND tax-free benefits. As mentioned above, your contributions are tax-deductible. Your money in your HSA compounds tax-deferred. Then, when you take your money out to pay qualified medical expenses, it’s not taxed—these withdrawals are tax-free.
Using HSAs
As I noted above, if use for qualified medical expenses, HSA distributions are tax-free. While the cost of medical in retirement is high, using tax-free funds will be quite helpful. However, you do not have to use this source of funds for health expenses. You could instead choose to let your HSA money grow and grow, compounding tax-deferred, for use later, maybe in retirement. It is important to remember when investing in an HSA that you have a long-term horizon. If you are using your HSA for retirement planning, you could have a significant additional amount of money at 65, or older. That money can stay in, growing with postponed tax consequence as long as you want, unlike an IRA with required minimum distributions. Similar to other long-term savings accounts, such as an IRA or 401K, most HSAs allow you to choose from a menu of mutual fund investments. As you know, great growth can come from these over time.
HSA Tax Penalties
If your withdrawals from an HSA are not used for qualified medical expenses, you will have a tax bill. Tax penalties from HSA withdrawals are both a function of your age and what you use the money for. As noted above, using your HSA money to pay qualified medical expenses is tax-free. However, withdrawals to pay for anything else will trigger either a tax penalty or an income tax liability, or both. The “both” case applies to HSA withdrawals before age 65 (again, only for non-qualified medical expense withdrawals). These withdrawals before age 65 will cost you a 20% tax penalty AND be taxable at your ordinary income tax rate. For example, suppose you take $5,000 from your HSA and use it for unqualified expenses before you are 65. Say your income tax rate 25%. That reduces your $5,000 to $3,750. The second tax, the 20% penalty, will take an additional $750, leaving you with only $3,000. It’s not so bad if you are over 65. After age 65, you can use your HSA withdrawal for non-medical expenses without paying the 20% tax penalty. Spend it any way you want. You just have to pay income tax that year on the withdrawal amount.
I encourage you to consider an HSA. Their benefits speak for themselves.
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