By Monica Jalife
Various programs have been implemented to give individuals incentives and tax advantages to help offset healthcare costs (current and future). The creation of Health Savings Accounts (HSAs) is one of them. HSAs were created as part of the Medicare Prescription Drug, Improvement and Modernization Act signed into law by President George W. Bush in 2003.
An HSA is a type of savings account that lets you set aside money on a pre-tax basis to pay for qualified medical expenses such as doctor and dentist visits, prescriptions and treatments.
To qualify for an HSA, you must meet the following requirements:
- Covered under a high deductible health plan (more on that later)
- You are not enrolled in Medicare
- You have no other health coverage
- You cannot be claimed as a dependent on someone else's tax return
If you meet these requirements, good news: You are considered an eligible individual. This is the case even if your spouse has coverage for the family under a non-high deductible plan (as long as you are not included in that plan).
OK, but what is a high deductible health plan (HDHP)?
A high deductible health plan has a higher annual deductible than most typical plans and includes a maximum out-of-pocket amount of medical expenses that you could pay in a given year. The IRS sets annual limits on the minimum annual deductible and the maximum out of pocket expenses. To put this into context, the minimum annual deductible for 2019 is $1,350 for single coverage and $2,700 for family coverage. Similarly, the maximum out of pocket amounts for single coverage are $6,750 and $13,500 for a family.
So, why consider an HSA?
An HSA may be used as another vehicle for retirement savings to cover future healthcare costs. Since HDHPs require higher deductibles, participants typically pay smaller monthly premiums for the health insurance in the plan. Moreover, companies and/or individuals can make monthly or annual contributions of funds to the HSA account. Contributions must be made in cash. Those funds can accumulate over time and any funds not used during the current year can be rolled over for future years. For 2019, the annual contribution limit is $3,500 for individual health coverage and $7,000 for family coverage. For people age 55 and older, an additional $1,000 catch up contribution is allowed.
A Triple Tax Advantage
A health savings account offers three separate tax benefits:
- You can fund your account with pre-tax contributions. This is money that will reduce your taxable income (at least at the Federal level; tax treatment differs by state). Every dollar an individual contributes from her paycheck will go entirely to the HSA account.
- Any investment earnings or interest is tax-free. HSA administrators typically require a certain minimum in an HSA to cover for unexpected medical expenses, but any funds above that threshold can be invested in stocks or bonds (through various investment options such as mutual funds and ETFs).
- Tax-free withdrawals. Typically, when contributions are made to a tax-deferred account, you are expected to pay taxes on that money once you start withdrawing it. Here's the beauty of HSAs: If that money is used for qualified medical expenses, the money will not be taxed (even if those expenses were incurred in previous years). And while you can take advantage of those tax-free benefits at any time, you might let those funds grow in your account and use them for medical expenses when you're retired. Please note that if the withdrawals are used for non-medical expenses before you're age 65, taxes will be incurred and there will be an additional penalty of 20%. After age 65, non-medical expense withdrawals will still incur taxes but will not have a penalty.
Can I open an HSA on my own if my employer doesn't offer one?
Absolutely. You can have and contribute to an HSA on a tax-advantaged basis even if your employer doesn't offer one. The main difference is how taxes are handled. If the HSA is through your employer, the money deposited into the account is on a pre-tax basis. With an individual HSA, you can make your own contributions and receive the tax benefit at the end of the year when you file your taxes.
You also can have more than one HSA if your total contributions do not exceed the annual limit. Look for an HSA that has low fees, ease of access, attractive investment options and interest. Providers include Optum Bank, Fidelity, HSA Bank, Lively, Health Equity, Further, and Health Savings Administrators, to name a few.
Is there a different way to fund my HSA, other than by my employer or my personal contributions?
Another possible way to fund an HSA is what is known as Qualified HSA funding distribution (QHFD). In this strategy, an individual will rollover funds (not to exceed annual contribution limits, including any other contributions to the account) from his/ her IRA to an HSA. This rollover is tax-free. Rolling the money from a traditional IRA to an HSA changes it from tax-deferred to tax-free (as long as you will use the funds for eligible medical expenses)
So, you have effectively reduced your IRA balance, without having to pay taxes. But, this is allowed only once in your lifetime, and it is per taxpayer, not per IRA.
Please be sure to follow all established guidelines by the IRS:
- It must be a direct trustee-to-trustee rollover (you can't get a distribution check and then deposit into the account)
- The HSA must remain eligible for 12 months after making the distribution or those funds will become taxable.
- You can use traditional IRAs, and Inherited IRAs to fund an HSA. A Roth IRA is also a possibility, but only pre-tax funds can be transferred over which can limit the amount from a Roth IRA to investment earnings.
And more good news: A QHFD counts towards required minimum distributions (RMD) for the year in a traditional or inherited IRA.
Speaking of inheriting, what happens to my HSA if I die?
It depends on who you have listed as your beneficiary. If it is your spouse, the account becomes his/hers and he/she can use it for qualified medical expenses tax-free. He/she would not need to have HSA-eligible health insurance to continue to hold the account. However, if he/she did and is eligible, he/she could make contributions to the HSA.
If you have a non-spouse beneficiary, the HSA loses its tax-free status and the fair market value of the account as of the date-of-death will become taxable to the beneficiary. If any portion of that account is used to pay the medical expenses of the account owner within one year of his/her death, those will not be taxable to the beneficiary.
If your estate is the beneficiary, the account's value will be included in your final income tax return.
These are important considerations to ponder as you determine your beneficiaries. If you are married, it may be a good strategy to list your spouse as the beneficiary as he/she will continue to enjoy tax benefits from that account after your death. If you are looking to set a different beneficiary, consider the potential tax implications a lump-sum distribution will have on them.
For example, let's say you want to leave your $150,000 HSA account to your daughter, who is in a high tax bracket, while you have a lower tax bracket. If you leave it to him/her directly, your spouse will have a year with an extra $150,000 in income (assuming nothing was used to cover for medical expenses for you, within a year of your death). In this situation, naming your estate as the beneficiary might work better since the value of the HSA would be included in your final income tax return and taxed at a lower rate, instead of your child's higher rate.
There are significant tax benefits of HSA accounts, and these accounts may be used as an additional savings vehicle to cover future healthcare costs and form part of your overall financial plan. Money can be invested pre-tax, earnings can grow tax-free, and withdrawals will not be taxed when used for qualified medical expenses.
I hope you find this primer helpful. In determining whether an HSA is right for you, please consult with your team of trusted advisers about your specific situation.
About the author: Monica Jalife, CFA, CFP, is a portfolio manager and principal with Withum Wealth Management. Important Disclosure: Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Withum Wealth Management "WWM"), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained herein serves as the receipt of, or as a substitute for, personalized investment advice from Withum Wealth Management. Withum Wealth Management is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice.