The most underused tax-savings vehicle: the Health Savings Account (HSA)

In summary

Health Savings Accounts (HSAs) let you save on taxes (like a 401k) when you contribute to them. They grow tax-deferred (also like a 401k/IRA), and if you use them for approved health costs*, the earnings are also tax-free! Unlike an FSA, the account is yours to take with you and the money never ‘expires’ (think of it like a healthcare spending IRA), and best of all, if you don’t use it for healthcare by the time you’re 65 years old, you can take it out with no penalty and just pay income taxes on it as those it were a 401k/IRA!

You must have an HSA-eligible health insurance plan to contribute (but not to use) an HSA, so check if your employer provides one and if the coverage makes sense for you (for most healthy people it does!)

Either open the HSA through your employer, or if you need to roll over an old HSA or you want to open one on your own, I highly recommend (and use) Lively, which has no fees, great customer service & website, and great investment options via a linked TD Ameritrade brokerage. (Yes, you can invest your HSA balance so that it can grow tax-free just like a retirement account! I keep a couple thousand for just-in-case health expenses in cash and invest the rest to grow for future needs for me or my family, since they can also use ‘your’ HSA.)

*out of pocket expenses, including on over-the-counter stuff like aspirin or feminine products, dental, and vision like contacts & contact solution). Generally you can’t pay for insurance, but if you’re on unemployment benefits or continuing your employer insurance with COBRA, you CAN pay for those premiums with your HSA.

Details

As health care costs in America continue to soar, so do health care insurance premiums.  The fortunate ones have access to quality, affordable, employer-sponsored group health insurance.  Those that are not so lucky?  Well, let’s just say your affordable options are somewhat limited (assuming you’re not independently wealthy and don’t want to “self-insure.”)

What does a “normal” health insurance policy cost for an individual?

A quick search on ehealthinsurance.com returns several plans with a wide range of premiums, coinsurance percentages, out-of-pocket maximums and coverages.***  The search I performed assumes that the policy holder (the person who’s buying the insurance) is a male non-smoker who lives in North Seattle and is 25 years old.  (Premium prices for a person who is 55 are in parentheses right next to our sample 25 year-old’s monthly premiums.)

Our sample person would pay $226 ($431) per month for a policy with a $500 deductible, 20% coinsurance after the deductible, and an out-of-pocket maximum of $4,500 (including deductible.)  The first 1-5 per year office visits to a primary doctor or specialist are exempted from the deductible.  All our person would have to cover is the $30 copayment (or “copay”, a typically small payment towards your health care per office visit.)  Also, prescription drugs are covered at a $20-$40 copay.

Health insurance is expensive!  How can I lower my premiums?

If that $226 ($431) monthly premium sounds pretty hefty to you (adding up to $2712 ($5172) per year), there are alternatives.  The easiest way to lower any kind of insurance premium is to increase your deductible.  This means that if you do use your insurance, more of the upfront costs will be born by you.  The benefit is that if you’re relatively healthy, you may not pay much out of pocket for health care, saving yourself the difference in premiums.  High-deductible health insurance is also referred to as “catastrophic” health insurance.  I.e: this type of insurance doesn’t pay much if anything for the small stuff, but if something terrible happens to you and you wind up in the hospital for a few days, you won’t be wiped out financially.

If we run our male 25-year old (55 year-old) search for high-deductible plans we find one with a $2,000 deductible, 10% coinsurance after the deductible, and an out-of-pocket maximum of $5,100 (including deductible.)  However, we don’t find any deductible exemptions for office visits on this policy.  Also, prescription drugs aren’t covered at all (which may be a consideration for our sample 55 year-old person.)

What’s the upside to the higher deductible (and out-of-pocket maximum) and the reduced benefits on this catastrophic policy?  Premiums are less than 30% (40%) of the lower-deductible policy at $65 ($168) per month.  Comparing our lower deductible and high-deductible policies, those premium differences amount to $1,932 ($3,156) per year in savings.  If you rarely go to the doctor, that could make a pretty big difference to you over the years, especially if you’re investing the difference and earning returns on that money each year.

Health Savings Accounts – how HSAs can help those considering high-deductible health insurance

The government has created a tax-advantaged device that might make high-deductible health insurance even more attractive to you.  This vehicle is called a Health Savings Account (HSA.)

The idea behind a Health Savings Account is fairly simple:

Step 1) An individual or family purchases a high-deductible (greater than $1,400 for individuals in 2021; $2,800 for families) health insurance option from any carrier they like (including your employer.)  The minimum deductible does NOT apply to preventative services.  Thus, you could have a plan that waives its deductible for routine office exams and immunizations that still qualifies for an HSA.  Also, the out-of-pocket maximum for an HSA-eligible plan must be less than $7,000 (for an individual in 2021;  $14,000 for families.)

Step 2) The same individual or family opens up an HSA, into which they can contribute up to the annual amount stipulated by the IRS.  For 2021, those annual limits are $3,600 & $7,200 for individuals & families respectively, with an extra $1,000 ‘catch up’ contribution for those who are 55 and up.

Note that a family can never contribute more than the family limit with all their combined employee + employer contributions. For example, if each spouse has their own HDHP + HSA, and one spouse is covering children on theirs, they can NOT contribute $7,200 to the kids+spouse plan and $3,600 to the individual. Each spouse can only contribute the $3,600 to each HSA.

Benefits of an HSA – Triple tax-advantaged!

– You can deduct contributions that you make to the HSA from your taxes** (without having to itemize.)  Also, you can invest in whatever you want, similar to an IRA.  In theory, any provider of IRAs is eligible to offer HSAs.  In practice, however, I haven’t heard of any brokerages or mutual fund houses that offer HSAs directly (but hopefully that will change as the HSA becomes more popular and widely known.)

** State tax treatment of HSAs varies. Depending upon the state, HSA contributions and earnings may or may not be subject to state taxes.  See THIS for information on your state.]

– Your contributions remain in your account from year to year until you use them (unlike Flexible Savings Accounts which are often “use it or lose it” for a given year.)

– The interest or other earnings on the assets in the account are tax free.

– Distributions are tax free if you pay for documented qualified medical expenses.  These expenses can include medical/dental/vision/chiropractic services, over-the-counter and prescription drugs, medical hardware like eyeglasses and hearing aids and long-term care insurance premiums (however, generally you cannot treat insurance premiums as qualified medical expenses for HSAs.)

Who’s covered?

The qualified expenses can be for you, your spouse, or any of your dependents (i.e.: children.)

What’s covered?

From the IRS, “the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and the costs for treatments affecting any part or function of the body. These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners. They include the costs of equipment, supplies, and diagnostic devices needed for these purposes.

Medical care expenses must be primarily to alleviate or prevent a physical or mental defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation.”

A large list can be found HERE, and includes all the ‘normal’ medical expenses one might think of (exams, hospitalization, treatment, lab fees, vaccines, surgery (NOT cosmetic!, medicine), as well as acupuncture, dental treatment & hardware (dentures, braces – but teeth whitening is NOT covered),  birth control, chiropractor bills, contact lenses (including saline solution), glasses (for vision correction), eye exams, laser eye surgery, hearing aids, and nursing homes & services.

There is also a list of things NOT covered, which includes cosmetic surgery, hair removal or transplant, funeral expenses, gym memberships, nonprescription medicine (e.g.: aspirin), and nutritional supplements (e.g.: vitamins).

What about insurance premiums?

In general, insurance premiums (the cost you pay to maintain your insurance) are NOT covered, since they aren’t direct payment for medical care.  However, you CAN use HSA money tax & penalty-free if you’re paying for 1) Long-term Care insurance (up to certain limits), 2) health care continuation coverage (COBRA), 3) insurance while you’re receiving unemployment benefits, and 4) Medicare premiums once you (or you AND your spouse if you’re covering your spouse) are 65 or older.  See Pub 969 for details.

What if you DON’T use the money for qualified medical expenses?

If you use the money for something else, you will pay a 20% fee on the money and income taxes (so DON’T do that!)  However, if you are 65 or older or disabled, you can withdraw the money for whatever you like and only pay regular income tax (avoiding the extra penalty, making the HSA similar to a Traditional IRA or 401k.)  After 65, you continue to withdraw your HSA money tax-free to pay for medical expenses.

Additionally, unlike Traditional IRAs and 401ks, there are NO Required Minimum Distributions (RMDs) for HSAs, so the money can continue to grow tax-free while you’re in retirement.

Furthermore, if the policyholder ends their HSA-eligible insurance coverage, he or she loses eligibility to deposit further funds, but funds already in the HSA remain available for use (1).  Your HSA is also “portable” in that it stays with you if you change employers or stop working.

In order to qualify for an HSA, you must be enrolled in a high deductible health plan (HDHP), you can’t be enrolled in Medicare, and you can’t be claimed as a dependent on someone else’s tax return for the year you enroll/contribute.  In 2014, a HDHP must have a MINimum annual deductible of $1,250 for an individual ($2,500 for a couple) and a MAXimum out-of-pocket maximum (INCLUDING the deductible) of $6,350 ($12,700) for ‘in-network’ coverage, if your plan is a in/out-of-network plan.  HDHPs MAY cover preventative care without requiring the deductible.

Your health insurance provider, and health care search engines like ehealthinsurance.com, can tell you whether your plan qualifies as a HDHP so that you (or your employer) can contribute to an HSA.

Conclusion

Health insurance can be tricky and somewhat complicated.  Besides looking at the financial side of things (premiums, coinsurance, out-of-pocket maximums) you need to be especially careful at reading through a potential policy to understand everything that’s covered, and more importantly, what isn’t.

HSAs are one way that a person might be able to save on health care costs.  However, to benefit you should be healthy (i.e.: need the doctor rarely in the future), in a tax bracket where the tax savings will give you a nice benefit, and making enough money and have the discipline to invest in your HSA.  Doing so successfully could result in significantly lower health insurance premiums, while allowing your HSA to grow tax-free until you either need it for medical expenses down the line, or you use it like a 401k/IRA after you turn 65.

Regardless of which health care option you choose for yourself or your family, make sure you understand it and make sure you enroll in one of those options!  Due to the high cost of health care, and the likelihood that something can happen to you at any moment, you can’t afford NOT to buy health insurance.  You may feel young and invincible (I sure do!), but all it takes is a car wreck or a sports accident to lay you up.  Often times these circumstances are completely beyond our control.  Your entire savings and assets could be wiped out (and you could accrue significant debt) by a few days stay at a hospital.

So, stay healthy (both physically and financially)!  Eat right, exercise, invest early and often and make sure you have health insurance to protect yourself and your family.

[To learn more about HSAs, check out the IRS’s Publication 969.]

***”Coinsurance” is the % of your covered health care costs that YOU will pay for AFTER you pay costs up to the amount of the deductible. (Therefore, if your coinsurance is 15%, you pay 15% of the costs after you pay the deductible amount and your health insurance company pays the balance of 85%.)

The policy’s annual “deductible” is the amount of health care costs that you will have to incur (per year) before your insurance company will help pay some of them.

The annual “Out-of-pocket maximum” is the total amount of money that you might be liable for, in one year, should you have to pay that much in health care costs that year.  This number sometimes includes the deductible and sometimes does not.

The monthly “premiums” equate to the amount you must pay to maintain your health insurance coverage.  For a given policy, premiums generally go up as you get older, as it becomes more likely that you will incur health care costs that your insurance provider will have to cover.

Here’s an example to show how all these parts of your health insurance policy work together: Let’s say Joe N. Shured has a policy which features a $1000 deductible and 20% coinsurance after that, with an out-of-pocket maximum of $5000, which includes the deductible.

In 2008, Joe goes in for a routine checkup which costs $250.  Since this amount is below his annual $1000 deductible, Joe pays for the whole $250 out of his own pocket.  Later in the same year, Joe breaks his arm skiing and has to go in for X-rays, a cast, etc.  His total bills for the broken arm are  $6750.  Since Joe had already paid $250 towards his deductible, the first $750 of his broken arm bills also goes towards the $1000 annual deductible (which he pays all himself.)  Now that Joe has paid health care costs in 2008 equal to his deductible, the coinsurance of 20% kicks in.  Joe therefore pays 20% of the remaining $6000 balance, which equals $1200.  His insurance company picks up the tab for the remaining $4800 (assuming his policy covers those types of medical expenses; always read your policy carefully!)

To date, in 2008 Joe has paid $1000 for the deductible plus $1200 after the coinsurance kicks in for an out-of-pocket total of $2200.  His insurance company has paid $4800 (for a total of $7000 in medical bills in 2008.)  Let’s say that Joe, the clumsly being that he is, falls down a flight of stairs later in 2008 and breaks both legs.  These leg bills come to a total of $20,000, after a couple days stay in the hospital.  At 20% coinsurance, you might think Joe would have to pay $4,000, but notice that Joe already has paid $2,200 out-of-pocket medical expenses this year.  Because Joe’s policy has an out-of-pocket maximum (including deductible in our example) of $5,000, Joe only has to pay $2,800 of the leg bills out-of-pocket.  (Because $2,200 + $2,800 = $5,000.)  His insurance company must pay the remaining $17,200 of bills.

Joe finally makes it out of 2008 without anymore scrapes.  However, on Jan 2nd of 2009, Joe celebrates State U’s touchdown a little too violently and gives himself a hernia.  His hospital bill for this is $225.  Since Joe is in a new calendar year, his deductible has reset to $1000 again, so Joe must pay the whole $225 himself.  (Joe’s annual out-of-pocket maximum is also back at $5000 for 2009.)

(1) http://en.wikipedia.org/wiki/Health_savings_account