An introduction to Health Savings Accounts (HSAs)
I think most would agree with me that 2020 has been one of the craziest years the world as a whole has experienced, at least in recent decades. In just 10 short months we have dealt with natural disasters, a global virus outbreak, extreme economic declines and increases, riots and outcries for social justice reform, and more—and to top it all off, it is an election year.
Personally, this year has made, or rather allowed me, to re-evaluate how I think about and approach many social and economic issues—one in particular that always seems to be a hot topic is healthcare.
Love it or hate it, healthcare is universal in the way that it’s something every single one of us will need at some point or another in our lifetime. For some, it can be a fairly insignificant need – get an annual physical and only intermittently visit a physician for infrequent sicknesses or emergencies. For others, it may be a daily battle of living with a chronic disability or suffering from a rare disorder with ineffective or new treatments. For the majority of us, we will fall somewhere in the middle of this spectrum.
With that being said, we can all agree that healthcare is an absolute need. Yet, there seems to be little consensus on how we manage and distribute healthcare on a large-scale. I want to make it clear that I’m not here to get political nor claim to have the answers to how healthcare should be handled by our leaders. What I do know, and I think we can all agree on is that health insurance and healthcare costs are on the rise.
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.
In this article, we’ll be talking about a powerful financial tool that can help significantly reduce healthcare costs and other medical-related expenses. This tool also happens to be available right now to most American’s, whether or not they are aware of it. What I’m talking about is a Health Savings Account, commonly referred to as an HSA.
What is a Health Savings Account?
First things first, let’s get started with some of the basics.
So, what exactly is a Health Savings Account or an “HSA”? As the name suggests, a Health Savings Account, or an HSA, is a special type of savings account with the specific and intended purpose of being used to save and pay for healthcare-related expenses both now and in the future. It really is as simple as that.
Well, sort of.
For the most part, it is as simple as that. However, I’ll have to admit that there are some nuances and important details that you should know about when it comes to HSAs. We’ll talk about these in more detail below, but for now a few of the key features to know about HSAs are this:
- In order to open and contribute to an HSA, you must be covered by a qualified high-deductible health plan.
- HSAs are a taxed-advantaged account. So long as used in the correct manner, money in and out of an HSA is completely tax-free.
- HSAs do not expire and the money rolls over from year to year.
- HSA money is yours and is not a use-it-or-lose-it account like other common health spending accounts.
- HSAs are a powerful retirement tool that can and should be used to complement other retirement savings.
- When used correctly, HSAs can reduce overall healthcare costs.
Who can use an HSA?
Similar to other tax-advantaged accounts allowed by the government, there are very specific eligibility requirements that you must meet in order to open, contribute to, and use an HSA. In most cases, you will just need to make sure that you meet two main requirements:
- Currently enrolled in a High Deductible Health Plan (“HDHP”); and
- You are a US taxpayer
On the flip side, there are also several events that can (and 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 100% of disqualifying events, it’s a pretty comprehensive list of the most common ones to keep in mind:
- 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 an HDHP?
A High Deductible Health Plan, or HDHP, is an insurance plan with higher deductibles and out of pocket costs; however, it does carry lower premiums than traditional insurance plans, and in most cases, the cost savings in premiums alone are significant.
Essentially what this means is that you will have lower monthly payments for your insurance coverage, but higher out-of-pocket medical costs before the insurance company begins paying.
How do you know if you are in an HDHP that qualifies for an HSA?
HSA-qualified health plans must meet minimum and maximum requirements for individual and family deductibles and out-of-pocket maximums. The limits are set and determined each year by none other than (you guessed it) the government.
Based on 2021 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 $7,000 for individuals and $14,000 for families compared to $6,900 for individuals and $13,800 for families in 2020.
2020 IRS Limits
|Single Plan||Family Plan|
|Max. Contribution Limit||$3,550||$7,100|
|Catch-up Contribution (55+)||$1,000||$1,000|
2021 IRS Limits
|Single Plan||Family Plan|
|Max. Contribution Limit||$3,600||$7,200|
|Catch-up Contribution (55+)||$1,000||$1,000|
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 and make eligible contributions to your HSA, you do NOT have to maintain eligibility in the future to use the money that you have already contributed to the account. Even after you lose eligibility to contribute to an HSA, for whatever reason, you are able to continue using the money saved in your HSA for qualified expenses.
For more information on whether or not you qualify for an HSA, I recommend that you check out IRS publication 969. It might not be the most exciting thing to read or take a look at, but it’s important to do so.
Why would someone use a Health Savings Account?
There are numerous reasons, and benefits, why someone would want to take advantage of using an HSA. Let’s explore some of these benefits below:
As I mentioned earlier in this article, healthcare can easily be one of the biggest expenses throughout our lives. An HSA is generally a more cost-effective way to handle these medical expenses. HSAs are designed to help you pay for your current healthcare expenses and save for future healthcare expenses in a tax-advantaged manner.
One of the greatest things about HSAs is the tax-free aspect of the account. So long as used correctly, the money that goes into and out of an HSA is tax-free, meaning that Uncle Sam can’t touch this (not to be confused with one-hit-wonder and 90’s singer MC Hammer).
Many compare the tax savings to that of a 401(k), but they are even better through an HSA. With an HSA you can make tax-deductible contributions, invest the contributions and earn interest tax-free, and take tax-free withdrawals to pay for qualified medical expenses. That’s what we like to call the triple-tax advantage of an HSA, which is nearly impossible to find with any other savings or retirement accounts.
We can even take the tax savings one step further if the HSA contributions are made through an employer cafeteria plan. Unlike pre-tax 401(k) and other employer-sponsored retirement plans, HSA contributions made through payroll are pre-payroll taxes (FICA/FUTA) as well.
Qualified medical expenses
In order to take full advantage of the HSA tax benefits, payments and reimbursements from the account must be used for Qualified Medical Expenses (‘QMEs’). Otherwise, withdrawals from the account are subject to income tax and may have additional penalties up to 20% if done before the designated retirement age at 65.
So, what exactly is a QME? QMEs are healthcare-related items or services designated by the IRS and include medical, dental, vision, and prescription expenses. There are literally 1000’s of procedures, services, and types of equipment that are considered QMEs, and the IRS frequently updates the list of what is included. Luckily, many health insurance and HSA providers have built some user-friendly tools where you can search their comprehensive databases to see what types of expenses qualify ahead of time. Personally, I’m a big fan of Lively’s eligibility search engine, but there are dozens of options available to choose from.
It’s also important to note another extremely important, yet often very misunderstood benefit of the HSA.
Your HSA funds do not expire.
Let me repeat that one more time.
Your HSA funds DO NOT expire. Ever. Period. Meaning that the funds in your HSA account roll over from year-to-year unlike some more-commonly known healthcare accounts like a Flexible Spending Account (FSA) where you either use the money or lose it at the end of the benefit year. Unfortunately, this all-too-common misconception deters many from ever contributing to an HSA.
This feature of an HSA provides you with a great amount of flexibility when it comes to using your HSA funds. You can spend money contributed this year tax-free on qualified medical expenses this year, next year, in 15 years, or even 100 years from now. This portability feature is extremely important and carries several benefits, including using these funds in retirement.
Last, but certainly not least, HSAs can also be a powerful retirement tool to complement your other retirement savings.
Once you hit retirement age at 65, you continue to receive the same tax advantages for qualified medical expenses but you can also withdraw and use your HSA funds as retirement income for everyday expenses the same way that you would, or can, from an IRA, 401(k), or other retirement accounts. The only downside is that any withdrawal from the HSA account will be taxed at your ordinary-income tax rate for the year if the funds are not used for qualified medical expenses.
The harsh reality is that the need for healthcare almost always increases with age but really starts to pick up speed at an alarming rate when nearing retirement age. Experts estimate that the average couple will need almost $300,000 for medical expenses in retirement – and that is excluding any expenses related to long-term care! For this reason, many financial experts are now starting to recommend using an HSA as a supplemental retirement account to reduce the overall tax impact of retirement spending.
An example of saving for retirement through an HSA
Let’s run an example and crunch some very basic numbers to understand the benefits of saving for retirement through an HSA.
Our first couple, Jack and Jill, are both about to turn 65 and are planning 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 are also planning to retire with $1,000,000 in retirement savings. However, Fred and Wilma have been putting money away into an HSA and have their savings split between that 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 will save compared to Jack and Jill by using their HSA for qualified medical expenses. To keep things similar and for the purpose of this example, we will also assume that their effective tax rates are both 25%:
|Savings Type:||Jack and Jill|
|Expense Type:||Amount||Taxes @ 25%|
|Savings Type:||Fred and Wilma|
|Expense Type:||Amount||Taxes @ 25%|
Just by reallocating some of their retirement savings to their HSA and using that money on medical expenses in retirement, Fred and Wilma have an extra $75,000 over Jack and Jill.
Some may argue that a ROTH IRA or 401(k) would do the same – but this is incorrect. With a ROTH account, you still have to pay taxes on the money when you contribute to the account.
Remember, HSA contributions are pre-tax and are never taxed when used to pay for qualified medical expenses. Something to always consider and keep in mind when planning your expected retirement outcomes.
How do HSAs and HDHPs help with rising healthcare costs?
Right away, higher deductibles and out-of-pocket maximums may seem to do the opposite of saving money, but let’s think about this for a minute.
Premiums paid each year are for the insurance company to keep regardless of how much or little you use your insurance that year. So, during a year where you have minimal medical expenses, the “extra” premiums you paid throughout the year don’t get refunded. This actually limits the flexibility of the plan to take into account years where your healthcare costs go up or down.
Now let’s look at someone with an HSA + HDHP that has lower insurance premiums. This individual can take the difference in premiums they would have paid, contribute those to an HSA (saving on taxes), and perpetually rollover any funds leftover in the HSA. This gives you more flexibility so that health insurance needs are met each year differently based on your health status.
Plus, having an HSA + HDHP should make you a better healthcare spender. That’s because you now have more skin in the game and have the incentive to shop around and make sure that you are getting the right care for the best cost.
From a macroeconomic perspective, more savvy and aware consumers of healthcare should and can drive down overall healthcare costs. When we are more aware of what treatments and medication we actually need and the costs of different options, we create a more competitive and transparent market for healthcare services. Healthcare providers are then forced to lower costs and have more transparent/upfront pricing in order to be competitive with others.
Let’s not forget about the rising cost of monthly insurance premiums. Over the last decade, health insurance premiums increased faster than both 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 is that they are also rising at a much slower and manageable rate than those of traditional health plans.
Order of savings
Now that we have discussed some really important things to help understand HSAs, let’s talk about one common question that we often get asked when first teaching someone about the power of HSAs: “how much should I contribute?”.
I generally like to break down the recommendation into three categories/steps that someone can follow to eventually get on the path to take full advantage of their HSA contributions.
Contribute enough to cover annual medical expenses
For individuals that are eligible for an HSA, this is the best place to start. At minimum, you should contribute at least enough to cover your medical expenses for the year in which you are eligible to contribute to an HSA.
Simply because of the tax savings of your HSA. You are going to have to pay for the medical expenses regardless, so you might as well ensure the money is tax free. You will immediately save a good chuck on those expenses depending on what your tax rate is for the year.
You can do this either by planning out how much you think you will need and contributing throughout the year, or you can pay the expenses out of pocket, contribute the same amount to your HSA, and then submit for reimbursement.
Contribute as much as you can or max out any employer contributions
You may not be in a place where you can contribute the annual maximums, and that’s okay. The next step to take is to either contribute as much as you possibly can or contribute at least enough to max out any matching that your employer does into the account.
Contribute the maximum for the year
The last step is to contribute up to the maximum limit for the year. This is obviously the step where you will be taking full advantage of the HSA contributions and can really start saving and investing.
Bonus, don’t use the money you contribute until retirement
Here’s a bonus recommendation that really doesn’t have to do with how much you contribute to your HSA: Do not use your HSA funds until you absolutely have to.
The best-case scenario is that you wait until retirement to use that money due to a unique feature called the shoebox method that allows you to reimburse HSA funds for qualified medical expenses ANYTIME after you become eligible to contribute to an HSA.
We’ve already discussed the tax advantages of using HSA funds for QME’s during retirement, but this feature allows you to use this money for non-healthcare expenses completely tax-free.
Essentially what you’re doing is paying for qualified medical expenses with non-HSA money, saving those receipts (maybe even in a shoebox, hence the name), and then submitting those receipts in retirement to get that money reimbursed to you tax-free.
Moving forward with Health Savings Accounts
While you might not be an HSA expert after reading this guide, hopefully, the information should arm 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 useful ways to better prepare now and for future healthcare needs and expenses.
I don’t believe that HSAs are the silver bullet that will fix our healthcare problems; however, it is one of the strongest tools available now to many Americans to help reduce costs and better their overall financial situation. So, the next step is to determine your eligibility and to start saving using your HSA!