Health Savings Accounts (HSA's) are becoming more widely used as people discover all of the benefits that they have to offer. No doubt, the continually rising cost of health care is also helping to push people to research the best options for paying for it all, both for pre-retirement, and, especially, for post-retirement. While health care expenses will vary greatly from person to person, and even from year to year, these accounts can be used at any age and actually offer the greatest advantages when you think long term (more on this below). However, before we get into the many benefits of HSA's there is one significant requirement to be aware of - to qualify for an HSA, you must participate in a high-deductible health insurance plan. This means that your health plan has an annual deductible of at least $1,400 for an individual, or $2,800 for a family. High deductible health insurance plans in and of themselves may not be right for everyone, but they do typically offer lower premiums than other plans and that can help to partially offset the high deductible amounts. Research your options carefully.
If you participate in a high deductible health insurance plan, here's the great news:
• You can set up an HSA through your employer, or you can do it on your own (if you are younger than age 65).
• All contributions are tax deductible. These deductions can be taken from your wages pre-tax, or they are tax deductible if you make a contribution with after tax dollars.
• You can contribute up to $3,600/year if single, or up to $7,000/year for a couple. You can contribute an additional $1,000/year if you are over age 55.
• Anyone can contribute to your HSA, not just yourself.
• All health care expenses can be paid from these funds through tax-free withdrawals.
• HSA balances over a certain amount, usually $1,000, may be invested. This is optional, and presents investment risk, but invested funds offer the opportunity to grow at a faster rate than funds just earning interest.
• Interest earned, or investment gains, are tax free as long as the funds are used for health care costs.
* If you choose to invest some of your HSA funds, be careful to leave enough in cash to pay for ~ 1 year of your estimated health care expenses so that you won't have to sell investments at an inopportune time just to make that money available for current expenses.
• If you have an HSA through an employer, and lose your job, the funds may be used to pay for COBRA payments.
• Most HSA accounts offer a debit card as a convenient way to pay health care expenses.
• An HSA account is "portable" - you can move it to a new employer if you switch jobs or to a new insurance company.
• Unlike Flexible Spending Accounts (FSA's), which have a "use it or lose it" requirement and only allow a $500 annual carryover, all HSA funds can grow until they are needed, have no withdrawal requirements, and do not expire.
• HSA's do not have an Required Minimum Distribution (RMD) requirement as 401k/IRA/Roth 401k's do.
• Funds may be withdrawn at any time. If the withdrawals are used for health care costs, they are tax free and there is no penalty. If the funds are used for any other reason, there is a 20% penalty on the withdrawal, and the withdrawal amount will be taxed as ordinary income. After age 65, funds can be withdrawn for any reason, without penalty, but will be taxed if not used for healthcare costs.
• An HSA may be inherited. If the beneficiary is a spouse, they may use the funds to pay for your health care expenses incurred before death and/or for their own health care expenses. If the beneficiary is not a spouse, they may inherit the HSA balance as taxable income. Any amount they use to pay for your health care expenses before death may be deducted tax free.
Because HSA funds never expire, the best opportunity to maximize the benefits is to start contributing to them at as early an age as possible. Estimate how much you may need for current expenses each year, and then contribute more than that so that your balance will grow over time. Think of an HSA as a 401k that is used only for health care. Contribute as much as you can, up to the contribution limits. You can use the funds as you need them, but saving early for your retirement years will take a lot of pressure off paying for health care costs as you age. A common estimate of health care costs in retirement, over a 20 year period, is ~$140,000 per person, or ~$285,000 for a couple. This can vary greatly, but keep in mind that health care costs are rising at a rate of ~6% per year, far above ordinary inflation. Anyone will need a significant amount of money to pay for 20-25 years of health care in retirement, and not having to use taxable withdrawals to pay for it can save you a lot of money. Even if you are fortunate enough to be very healthy up until the day you die, medicare and minimal co-pays over 25 years could easily cost ~$70,000. Any hint of medical issues, at even a reasonably small cost of $1,200 year, would raise that to $100,000. Having to pay $100,000 using taxable withdrawals from 401k/IRA accounts could cost an additional $15,000 - $20,000 due to the taxes owed. Save little by little now, save a lot on taxes later.
Aside from the obvious financial advantages of an HSA, having a dedicated source of funds to pay for health care during retirement can offer peace of mind at an important time. Since annual contributions are limited, that makes it even more important to contribute to an HSA regularly over time. The more you can build your balance, the more you will benefit later on. Indeed, every time you contribute to other retirement accounts, consider funneling a small part of that contribution into an HSA. This does not take away from dedicated retirement funds, it simply places money that will certainly be needed into a more tax efficient account. There's nothing better than saving pre-tax money on the way in, letting it grow, and taking it all back out tax free as well. That's even better than a Roth account!