Have you heard of a health savings account, or HSA? This special account lets you pay for medical expenses with pretax dollars. It can help you save money on health care in the short term and well into the future.
This article will cover the basics of these tax-advantaged accounts:
- Who can contribute to an HSA?
- How HSAs can save you money.
- Which expenses are HSA eligible?
- How health-plan choice can cost you money.
- Using an HSA in retirement.
This information might help you see if an HSA could benefit your overall financial wellness.
Who can contribute to an HSA?
Having a specific type of health insurance is necessary if you want to contribute to an HSA.
“As long as you’re covered under a qualified high-deductible health plan [HDHP], you are eligible to make tax-advantaged HSA contributions,” said Joe Malzacher, managing advisor of BKS-Partners, an insurance and financial services broker. “The key here is that the plan must be qualified. There are many high-deductible plans that don’t meet the IRS definition of ‘qualified,’ so be sure your plan meets the IRS definition.”
You should check with the plan provider to make sure it qualifies, but, in general, a qualified HDHP must meet two main criteria:
- The deductible (what you pay out of pocket before your insurance kicks in) is at least $1,400 for an individual policy ($2,800 for a family policy; and certain family plans with individual deductibles do not qualify).
- The maximum annual deductible and out-of-pocket maximum is $6,900 for an individual policy ($13,800 for a family policy).
These dollar amounts apply in 2020 and may increase in the future.
You also can’t have any “first-dollar” health insurance coverage. (First dollar coverage is an insurance policy feature that provides full coverage for the entire value of a loss without a deductible.) Nor can you be enrolled in Medicare or be claimed as a dependent on someone else’s tax return. Complete details are available in IRS Publication 969.
“Since the health savings account is technically owned by the employee or individual, even if your employer doesn’t sponsor or fund a health savings account, you can open one with your bank or credit union and make after-tax contributions,” Malzacher explained. “The tax break [deductibility of contributions] is deferred until you complete your taxes, but you’ll still get the tax advantage [and tax-deferred accumulation].”
For 2021, you can contribute up to $3,600 to an HSA if you have an individual policy and up to $7,200 for a family policy. The contributions don’t have to come out of your own pocket, either. For example, an employer can contribute to an employee’s plan, and a parent can contribute to their adult son's or daughter’s plan.
How HSAs can save you money
Did you know that an HSA can save you 25 to 50 cents in taxes for every dollar you put in? When you tell your employer you want to contribute to an HSA, contributions will come out of your paycheck tax free. You won’t pay federal, Social Security, or Medicare taxes on the money. You also won’t pay state taxes on the money, unless you live in California or New Jersey.
Here's an example: Let’s say you’re in the 24 percent federal income tax bracket and the 5 percent tax bracket for your state. For every $1,000 you contribute to an HSA via payroll deduction, you’ll save the following in taxes:
- Federal: $240
- State: $50
- Social Security: $62
- Medicare: $14.50
- Total: $366.50
If you don’t contribute to your HSA through payroll deductions, you don’t get the Social Security or Medicare tax savings, unfortunately.
If you’re 55 or older, you can contribute an additional $1,000, and so can your spouse, for a total of $9,200. That’ll shave more off your tax bill.
In addition, employers sometimes contribute to their employees’ HSAs to encourage enrollment and contribute to their staff’s financial wellness. Getting this “free” money can be another great reason to contribute to an HSA.
Employers benefit when workers sign up for high-deductible health plans because these plans have lower premiums. Since employers often cover a large portion of their workers’ health insurance premiums, the savings can be significant. Lower premiums mean less money out of your pocket each month, too — which, along with the tax savings, frees up cash to fund your HSA.
Which expenses are HSA eligible?
Once you’ve funded your HSA, you can use the money at any time to directly pay or reimburse yourself for any qualified medical expense as explained in IRS Publication 502, Medical and Dental Expenses.
Here are some examples of qualified medical expenses:
- Prescription drugs.
- Vision correction surgery.
- Transportation, car expenses, and parking fees for medical treatment.
- Mental health care.
- Lab tests.
- Eye exams, eyeglasses, contact lenses, and contact solution.
- Chiropractic adjustments.
- Qualified long-term care insurance contracts.
- Qualified long-term care expenses.
You cannot use an HSA to pay for things the IRS does not allow:
- Teeth whitening.
- Health club dues.
- Medical marijuana (even if legal in your state, because it is not legal at the federal level).
- Health insurance premiums (unless you’re unemployed).
Some items fall into gray areas. Vitamins, supplements, and over-the-counter drugs are generally not eligible. However, if your doctor prescribes them to treat a specific, diagnosed condition, they are. Additionally, coronavirus relief legislation allows HSA funds to be used for some over-the-counter medications without a prescription, as well as certain other health-related products.
Similarly, cosmetic surgery generally is not a qualifying expense, unless it is related to a congenital abnormality, accident, trauma, or disfiguring disease.
How your health plan choice can cost you money
Despite the lower premiums of high-deductible health plans and the tax savings from funneling money into an HSA, this arrangement can backfire if you end up needing lots of health care.
When choosing your health insurance, if you’re healthy and don’t anticipate major health care expenses in the coming year, an HDHP and HSA may be right for you. Make sure you have enough savings to cover your deductible right away.
Choosing this option can have drawbacks. You can’t predict whether you might break a bone or get a serious diagnosis in the coming year. The best you can do is make an informed choice after considering your medical history and getting a complete physical examination.
“People who don’t anticipate spending too much on health care in a given year do well with an HSA because they can use it for small to medium eligible medical and health purchases, like contact lens solution, but they can also mainly purpose it as a savings vehicle,” said Jonna Reczek, marketing administrator for Benefit Resource, Inc., a third-party administrator of tax-free accounts, including HSAs, flexible spending accounts (FSAs), and health reimbursement accounts (HRAs).
It may not be the right time for you to try out an HDHP and HSA if...
- You anticipate major health care expenses in the coming year.
- You have a condition that requires ongoing treatment.
- You usually meet your deductible every year.
- It would be a strain to pay a higher deductible.
“Up until recently, HSAs have not been a great fit for people who anticipate large medical expenses in the beginning of the year or regularly throughout the year, such as expensive monthly prescription refills,” Reczek said. “This is because HSAs are funded through payroll deductions, so the funds in the account take time to build.”
It can be easy to deplete your funds in these circumstances. However, some employers have started making employees’ entire annual HSA deferrals available on day one of the plan year, similar to a traditional FSA. It’s a risky move for employers, but it makes the idea of an HDHP less frightening to employees, she explained.
Another thing that may reduce your risk is that preventive care services such as routine physicals and immunizations might be available with an HDHP before meeting your annual deductible.
Make sure you won’t need your HSA money for anything other than qualified medical expenses. If you do, you’ll owe income tax on the distributions and, if you’re younger than 65, you’ll also owe a 20 percent tax penalty.
How you can use an HSA for retirement
While you can only contribute to an HSA in years when you have an HDHP, you can spend the money on qualified medical expenses at any time. You can also save and invest the money indefinitely. (Learn more: Health savings accounts for retirement planning: Pros and cons)
“Investments [in an HSA] grow tax free, and as long as you use your account for qualified medical expenses, taxes won’t be due on the withdrawals, either,” Malzacher said. “Inflation will erode your buying power, and medical inflation is significantly outpacing current inflation rates.”
Many people don’t have the cash flow to invest their HSA funds for the long run instead of using the money to pay for current-year medical expenses. But it’s still a good idea to give yourself the option by choosing an HSA trustee (typically a bank or insurance company) that provides investment options.
HSAs can be a great financial wellness tool because of their triple tax advantage:
- No income tax on contributions.
- No income tax on investment gains.
- No income tax on distributions to pay for qualified medical expenses.
However, the risks can outweigh the benefits for people with high medical expenses or difficulty paying a high deductible. So, before you enroll in a high-deductible health plan and open an HSA, evaluate your unique financial and medical circumstances to see if these choices are right for you.
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This article was originally published in March 2019. It has been updated.