An introduction to Health Savings Accounts (HSAs)
Love it or hate it, healthcare is universal in the sense that at some point in our lives, every single one of us will have to rely on it. Unfortunately, there is little consensus about the best way to manage and distribute healthcare on a large scale. Health insurance and healthcare costs are on the rise and have been for the last two decades. Even when shared with an employer, monthly premiums are becoming less and less affordable. Deductibles and out-of-pocket expenses are through the roof. Network providers are shrinking, and visits, treatments, prescriptions, and procedures are more costly than ever.
However, in this article, we’ll be talking about a powerful financial tool that can help significantly reduce healthcare costs now and help you cover healthcare costs and other costs in retirement. This tool is available right now to most Americans, and it is called a Health Savings Account, more commonly known as an HSA.
What is a Health Savings Account?
As the name suggests, a Health Savings Account is a special savings account used to pay for healthcare-related expenses. We’ll go over all the features of an HSA in more detail below, but for now, here are a few of the key features you should know about:
- You must be covered by a qualified high-deductible health plan to open an HSA.
- HSAs are tax-advantaged accounts. So long as you use it correctly, money that moves in and out of an HSA is 100% tax-free.
- HSA funds do not expire, and they roll over from year to year. It is not a use-it-or-lose-it account like other common health spending accounts.
- An HSA is a powerful retirement tool that you can use to complement other retirement savings.
- When used correctly, HSAs can reduce overall healthcare costs.
Who is eligible to use an HSA?
Similar to other tax-advantaged accounts allowed by the government, there are specific eligibility requirements that you must meet to use an HSA. In most cases, you will just need to make sure you meet the following two requirements:
- You are currently enrolled in a High Deductible Health Plan (“HDHP”)
- You are a US taxpayer
On the flip side, several events will disqualify you from being HSA-eligible, even if you’re covered by a qualified HDHP and are a US taxpayer. While the list below doesn’t include all disqualifying events, these are the most common ones:
- You cannot be claimed as a dependent on another person’s tax return.
- You or a spouse cannot be covered by any other disqualifying insurance coverage such as Medicare.
- You or a spouse cannot be covered by a full-purpose Flexible Spending Account or Health Reimbursement Arrangement.
What Is a High Deductible Health Plan?
A High Deductible Health Plan, or HDHP, is an insurance plan with higher deductibles and out-of-pocket costs. However, HDHPs carry lower premiums than traditional insurance plans, and in most cases, the cost savings in premiums alone are significant.
This means that if you have an HDHP, you will have lower monthly payments, but your out-of-pocket medical costs will be higher.
How do you know if you have an HDHP that qualifies for an HSA?
HSA-qualified health plans must meet specific requirements for individual and family deductibles and out-of-pocket maximums. Based on IRS guidelines, HSA-qualified health plans must have minimum deductibles of $1,400 for individual coverage and $2,800 for family coverage. In addition, qualifying plans must have maximum out-of-pocket amounts of less than $7,050 for individuals and $14,100 for families compared to $7,000 for individuals and $14,000 for families in 2021.
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For the months where you are contributing to your HSA, it’s important to know that you must be covered by an HDHP on the first day of that month. However, once you open an HSA and make eligible contributions, you do NOT have to maintain eligibility if you want to use the money that you already contributed to the account in the future.
For more information on whether or not you qualify for an HSA, check out IRS publication 969. It might not be the most exciting read, but it is a valuable resource for anyone considering an HSA.
Qualified medical expenses
Remember how we said that money that goes in and out of an HSA is tax-free if used correctly? Well, for that money to be tax-free, payments and reimbursements from the account must be used only for Qualified Medical Expenses or QMEs.
So, what is a QME?
QMEs are healthcare-related items or services designated by the IRS that you can write off when you do your taxes. There are thousands of medical procedures, services, and types of equipment that are considered QMEs, and the IRS frequently updates the list. Luckily, health insurance and HSA providers have built some user-friendly tools where you can search to see which expenses qualify ahead of time. One helpful tool is Lively’s eligibility search engine, but there are dozens of tools you can use.
Why would someone use a Health Savings Account?
There are many reasons why someone would want to take advantage of an HSA. Let’s explore a few of those reasons.
Healthcare is easily one of the most significant expenses you will face over your lifetime. Because money used for QMEs comes out of an HSA tax-free, HSAs are generally a more cost-effective way to handle health expenses.
Many compare HSA tax savings to those of a 401(k), but they are even better! With an HSA, you can make contributions, invest those contributions, earn interest, and even take out withdrawals to pay for QMEs, all completely tax-free. That is widely known as the triple tax advantage of an HSA, which is nearly impossible to find with any other savings or retirement account.
You can even take these tax savings one step further if you make HSA contributions through an employer cafeteria plan. Unlike pre-tax 401(k) plans and other employer-sponsored retirement plans, HSA contributions made through payroll are pre-payroll taxes (FICA/FUTA) as well.
Again for the people in the back, your HSA funds do not expire. Ever. Period. Unlike other health spending accounts like Flexible Spending Accounts (FSAs), the funds in your HSA account roll over from year to year. Unfortunately, the all-too-common misconception that an HSA is a use-it-or-lose-it account deters a lot of people.
Because your HSA funds never expire, you can spend the money you contribute on qualified medical expenses this year, next year, in 15 years, or even 100 years from now, completely tax-free. This portability feature is significant and carries several benefits, including the ability to use funds from your HSA in retirement.
Last but certainly not least, HSAs can be a powerful retirement tool to complement your other retirement savings.
Once you hit the retirement age of 65, you continue to receive the same tax advantages for qualified medical expenses with your HSA. However, you can also withdraw HSA funds for everyday expenses the same way you would use an IRA, 401(k), or other retirement accounts. The only downside is that any withdrawal from your HSA account that you don’t use for QMEs is taxed at your regular rate.
Experts estimate that the average couple will need almost $300,000 for medical expenses in retirement, not including any expenses related to long-term care. For this reason, many financial experts now recommend that you use an HSA as a supplemental retirement account. Having multiple retirement accounts can help reduce the overall tax impact of retirement spending.
An example of saving for retirement with an HSA
Let’s look at an example to see how using an HSA can save you money during retirement.
Our first couple, Jack and Jill, are about to turn 65 and plan to retire with $1,000,000 in retirement savings. All of their savings are in a pre-tax 401(k) account.
Our second couple, Fred and Wilma, are also about to turn 65 and plan to retire with $1,000,000 in retirement savings, just like Jack and Jill. However, Fred and Wilma have split their savings between an HSA and a pre-tax 401(k) account.
Assuming that both couples will have $300,000 in healthcare-related expenses in retirement, let’s see how much money Fred and Wilma save compared to Jack and Jill using their HSA for qualified medical expenses. For this example, we will assume that both couples have an effective tax rate of 25%.
As you can see, just by reallocating some of their retirement savings to an HSA and using that money on medical expenses in retirement, Fred and Wilma save an extra $75,000 over Jack and Jill.
Some may argue that a Roth IRA or Roth 401(k) would provide the same benefits, but that is incorrect. With a Roth account, you still have to pay taxes at the time of contribution. Even if you were in a lower tax bracket when you contributed to your Roth account, an HSA would still save you more money throughout retirement when used for QMEs.
Remember, HSA contributions are pre-tax, and they are never taxed when used for QMEs; something to keep in mind when planning for retirement.
How do HSAs and HDHPs help with rising healthcare costs?
At first, you may read “higher deductibles and out-of-pocket maximums” and think that does the opposite of saving you money, but let’s think about this for a minute.
Premiums paid each year are the insurance company’s to keep. Some years, you might need enough care that you get a decent return on what you spent in premiums. Most years, however, you will likely have minimal medical expenses, so the premiums you pay throughout those years are effectively lost to you.
An Example of an HSA and HDHP Working Together
Say you take the difference in premiums you would have paid and contribute to an HSA (saving on taxes). All of that money is yours to keep, and any leftover funds in your HSA perpetually roll over from year to year. This gives you more flexibility to ensure that you meet your health care needs each year while saving money in the long run.
Another upside to using an HSA alongside an HDHP is that it can make you a better healthcare spender. Because you have more skin in the game, you have more incentive to shop around and ensure that you are getting the best price on the care you need. More savvy and aware consumers of healthcare can also drive down overall healthcare costs at a high level. When we are all more aware of which treatments and medications we need and the price of different options, we create a more competitive and transparent market. Healthcare providers are forced to lower costs and be more transparent with their pricing because we, the consumer, understand our options.
Let’s not forget about the rising cost of monthly insurance premiums. Over the last decade, health insurance premiums increased faster than wages and inflation, and the experts don’t anticipate the increase to slow down anytime soon. High-deductible health plans have significantly lower monthly premiums when compared to traditional, lower-deductible plans (which typically cost $800-$1,500 monthly depending on the type of coverage). Another benefit of HDHPs is that their premiums are rising at a much slower rate than those of traditional health plans.
How much should I contribute to an HSA?
Now that we understand what HSAs are and how we can use them, let’s talk about one common question that we often get about HSAs: “how much should I contribute?”
It generally makes sense to break down the answer into three phases that someone can follow to eventually get to where they are taking full advantage of their HSA.
Phase 1: Contribute enough to cover annual medical expenses
For individuals that are eligible for an HSA, this is the best place to start. At a minimum, you should contribute enough to cover your estimated medical expenses for the year in which you are eligible to contribute to an HSA.
You will have to pay for medical expenses regardless, so you might as well take advantage of the tax savings that come with an HSA. Depending on your tax rate for the year, you could save a good chunk of change.
You can accomplish this first step in one of two ways. The first option is to plan out how much you think you will need for the year’s medical expenses and contribute throughout the year. The other option is to pay for medical expenses out of pocket, contribute the amount spent to your HSA, and then submit for reimbursement.
Phase 2: Contribute as much as you can and max out any employer contributions
If you are contributing enough to cover your annual medical expenses, and you feel like you can contribute a little more, then do it! You may not be in a place where you can contribute the annual maximums yet, and that’s okay. Just contribute as much as you can. And, if you have an HSA through your employer, make sure you are maxing out any match program they may have. That’s free money that you don’t want to miss out on. Before moving on to the next phase, you should also work to maximize other employer contributions, such as a 401(k).
Phase 3: Contribute the maximum for the year
The last phase is where you strive to contribute the maximum amount each year, allowing you to take full advantage of your HSA. In this phase, your savings will start to grow, and as you invest them wisely, they can grow significantly from year to year.
Bonus: Don’t use your HSA funds until you have to
Here’s a bonus recommendation that doesn’t have to do with how much you contribute to your HSA: Don’t use your HSA funds until you have to. The best-case scenario is that you don’t have to use any of the money in your HSA until retirement.
One way to avoid using your HSA funds is to pay for qualified medical expenses out of pocket whenever possible, save the receipts, then submit for reimbursement from your HSA later on. With an HSA, you are allowed to submit for reimbursement anytime after you become eligible to contribute, meaning you don’t have to submit a reimbursement right away if you don’t want to.
Rather, you can employ what is often called the “shoebox” method. With this method, you pay for QMEs with non-HSA funds and save the receipts to submit for tax-free reimbursement later. These reimbursements can be used in the short term to pay for large expenses that come up like a child’s wedding, a new car, or tuition. However, you can also wait and use HSA reimbursements to pay for retirement expenses, allowing you to continue to increase and invest your HSA funds in the meantime, and get tax-free money to spend on day-to-day expenses in retirement.
Moving forward with Health Savings Accounts
While you might not be an HSA expert after reading this guide, hopefully, the information included arms you with enough knowledge to start taking advantage of the many available benefits. Healthcare is such a critical part of our lives, but it is complex. Fortunately for you, we have outlined some easy and practical ways to better prepare for future healthcare needs and expenses.
While HSAs are not a silver bullet that will fix our healthcare problems, they are still one of the strongest tools available to help many Americans reduce costs and better their overall financial situation. So, what are you waiting for? Determine your eligibility and start saving with an HSA today!