Health Savings Accounts (HSA) are an excellent way to pay for medical expenses. As described below, they offer unparalleled tax benefits and can be used in a number of creative ways to achieve a variety of financial goals.
As a refresher, those with high deductible health insurance plans can open an HSA. There are annual contribution limits, currently $3,350 for individuals and $6,750 for families. These limits can change from year to year. Next year, for example, the limit for individuals rises to $3,400, while the family limit stays the same.
An HSA is intended to help individuals and families offset the growing costs of healthcare. As you’ll see below, an HSA can accomplish this goal and so much more:
- An HSA offers triple tax benefits: An HSA is the crown jewel of tax deferred accounts. It combines the advantages of both a traditional and Roth retirement account. Contributions to an HSA are not taxed. Funds in an HSA grow tax-free. And distributions for qualified medical expenses are not taxed. It’s the closest thing a free lunch you’ll find anywhere.
- An HSA can grow from year to year: Unlike a Flexible Spending Account, an HSA is not “use it or lose it.” Your balance can continue to grow year after year. In fact, one could wait for decades before using the funds in an HSA.
- An HSA balance can be invested: Funds in an HSA can be invested in mutual funds. The best HSA accounts offer low-cost index funds as investment options. For those looking to invest their HSA contributions, the investment options are a key consideration when selecting an HSA administrator. You’ll find a comprehensive list of options here.
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- An HSA can pay for prior year medical expenses: As long as the HSA was established before you incurred the medical expense, an HSA can be used to reimburse that expense years later. For example, if an HSA was established in January 2016 and the medical expense incurred in June 2016, one could wait years before seeking reimbursement for that expense. The key is to maintain good records of the expense. As explained by the IRS, the HSA beneficiary “must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year.” And that leads us to the following two HSA strategies.
- An HSA makes for a good emergency fund: With this strategy, an HSA beneficiary pays for medical expenses from taxable accounts, but saves the medical receipts. Funds in the HSA continue to grow tax-free. When an emergency arises, you can seek reimbursement for past medical expenses sufficient to cover the emergency.
- An HSA can provide retirement benefits: The above strategy can also be used to save for retirement. Here, however, an HSA offers an interesting twist. Imagine you reach retirement having saved years of medical receipts. Reimbursement for these expenses are of course free of taxes. But what if you don’t have sufficient medical expenses to exhaust the HSA balance? In these circumstances an HSA acts similar to a traditional IRA. Distributions can be made from an HSA for non-medical expenses. These distributions will be taxed, just like a traditional IRA. For those 65 and older, however, there is no 20% penalty levied. Note that with an HSA, one needs to be 65 or older to avoid the penalty, not 59 1/2, which applies to IRA and 401k accounts.
- An HSA can pay for COBRA premiums: An HSA generally cannot be used to reimburse the cost of health insurance premiums. One exception to this rule is the cost of COBRA. For those that have separated from their employer and are relying on COBRA for health benefits, these costs can be reimbursed with an HSA, according to the IRS.
- An HSA can pay for Medicare premiums: As with the COBRA exception, an HSA can also be used to pay for Medicare Part B, Part D and Medicare Advantage premiums, so long as you are 65 or older. Note that a Medicare supplemental policy, such as Medigap, is not an eligible expense. An HSA can also cover an employee’s premiums at work if they are 65 or older.
- An HSA’s Establishment Date is critical: An HSA’s establishment date is key. While you can wait years to reimburse a medical expense, the expense must have incurred after the HSA’s establishment date. That means one should open an HSA, assuming they have a high deducitble plan, as soon as possible.
- An HSA survives a change in health insurance plans: Just because you change insurance plans doesn’t mean you need to close your HSA. And that’s true even if your new plan is not a high deducible policy. An HSA can be used to reimburse eligible medical expenses, even if they are incurred under a health insurance plan that wouldn’t qualify for an HSA.
- An HSA has a catch-up contribution: Most are familiar with the catch-up contributions available in a 401k or IRA. You may not realize, however, that an HSA also offers a catch-up contribution. Those 55 or older can add an extra $1,000 to an HSA.
- An HSA is treated differently in California: I recently recorded a podcast on HSAs, and a listener emailed me about California. It turns out that HSA contributions are not deductible from California state income tax. It’s therefore important to confirm your state’s treatment of HSA contributions.
- An HSA and a FSA don’t mix: As pointed out by Vanguard, you can’t have an HSA if you have other health coverage that will pay for medical expenses before your high deductible is met. Where this may frequently occur is if your spouse has a Flexible Spending Account.
- An HSA can cover more than medical expenses: Qualified expenses also include dental and vision related costs. I recently had an eye exam and purchased new prescription glasses. Both of these expenses can be reimbursed from our HSA, according to IRS Publication 502.
posted by SocialHSA