Health Savings Accounts (HSA): The Basics

Most investors know about the major tax-advantaged accounts. They have a 401(k), which forms the backbone of their retirement portfolios. They might have a Roth IRA, which for high-income professionals is funded indirectly as a backdoor Roth IRA. 529 plans are a great way to get tax benefits for saving for college.

However, health savings accounts can offer more tax benefits than any of these more common investment accounts. In this article, we review the basics of health savings accounts (HSA).

Eligibility

To be eligible for a health savings account, you need to enroll in a high-deductible health plan. In general, this means that you need to have a deductible of at least $1,350 for self-only plans and $2,700 for family plans, as well as an out-of-pocket maximum of $6,650 for self-only plans and $13,300 for family plans in 2018. These amounts are much higher than the typical health insurance offered by employers. As a result, your out-of-pocket costs could potentially be much higher with an HSA than with a lower-deductible health insurance plan.

On the other hand, for a healthy person, do you really need to have such a low-deductible plan? The high-deductible health plan is usually cheaper than the standard health insurance plan, and offers you the ability to contribute to an HSA.

Who should consider enrolling in an HDHP?

When it comes to health insurance, most people fit into two categories: those who use health insurance for insurance, and those who use health insurance as a subsidy for their medical costs.

If you’re someone who uses health insurance as a subsidy for your medical costs, and you know that you will always go through your deductible and get close to your out-of-pocket maximum, then you should stick with your standard health insurance plan and not participate in an HSA.

However, if you’re someone who uses health insurance as insurance, then you should strongly consider enrolling in a high-deductible health plan. You’ll pay lower premiums and have access to contribute to an HSA.

Triple-Tax Benefits of the HSA

You don’t have to participate in an HSA if you have a high-deductible health plan. But some employers will automatically enroll you in an HSA and contribute some money into your HSA account if you choose the high-deductible health plan. You can then contribute additional money to an HSA, either through a payroll deduction or through ad hoc contributions.

The contribution limits for an HSA in 2018 are $3,450 for taxpayers with a self-only HDHP and $6,850 for taxpayers with a family HDHP.

When you contribute to an HSA, you get three tax benefits:

1. Contributions to an HSA are tax-deductible: Not only are contributions generally exempt from federal and state income taxes, you don’t have to pay Medicare or Social Security taxes on contributions either if you contribute through a payroll deduction.
2. Tax-free growth: As the money grows, you don’t have to pay taxes each time you sell investments for a profit.
3. Tax-free withdrawals for eligible healthcare expenses: If you withdraw the money for eligible healthcare expenses, the money can be withdrawn tax-free.

Other tax-advantaged accounts will only give you two of these three tax benefits.

• A 401(k) will give you an upfront tax deduction and you can defer capital gains, but you have to pay taxes on withdrawals.
• With a Roth IRA, you can defer capital gains taxes and then you don’t have to pay capital gains taxes at all if withdrawn after a certain age.
• A 529 will offer tax-free growth and tax-free withdrawals for eligible college expenses, but no upfront federal tax deduction (some states do offer a state tax deduction for eligible 529 contributions). With an HSA, you get all three tax benefits.

What if I have more money in the HSA than I would need for healthcare costs?

Investors should not worry about having to eventually spend the HSA money on healthcare expenses. The HSA effectively turns into a 401(k) at the age of 65. You can withdraw money for any purpose (including non-healthcare expenses) after the age of 65 and pay ordinary income taxes on the withdrawal, similar to a traditional 401(k).

However, if you withdraw money for non-healthcare expenses before the age of 65 and are not disabled, you’ll have to pay ordinary income taxes on the withdrawal, plus a 20% penalty.

Withdrawing money now or paying later with receipts

There are two ways you can withdraw money from your HSA to pay for healthcare expenses. The first, and more standard, option is to withdraw money from your HSA to pay for healthcare expenses. You can even have the HSA directly pay your doctor in many cases.

The second way to withdraw money is to simply pay for your healthcare costs out-of-pocket and save the receipts for later reimbursement from your HSA. You don’t have to immediately request to be reimbursed through an HSA withdrawal; as long as you keep your receipt, you could potentially wait years to get reimbursed through a tax-free withdrawal.

The benefit of delaying your HSA withdrawal is that you maximize the tax-deferral benefit. Using this method does require additional record-keeping, because you will need to keep your receipts in order to withdraw the money in the future.

Conclusion

If you’re relatively healthy, you should consider purchasing a high-deductible health plan and contributing to a health savings account. Unlike a 401(k), Roth IRA, or 529, the HSA offers three forms of tax benefits (upfront tax deduction, tax-free growth, and tax-free withdrawals for eligible healthcare expenses). You don’t even have to spend the money on healthcare expenses, as the account functions similarly to a 401(k) after the age of 65.

What do you think? Do you have an HSA? If so, do you withdraw money as you pay for healthcare or do you keep your receipts? Do you have any questions about how an HSA works?