Understanding the Power of Health Savings Accounts
Despite having been around for over a decade many young professionals still don’t understand how the hidden powers of a Health Savings Accounts (HSAs) can be utilized to improve their personal finances. Not understanding or taking advantage of these powerful vehicles can be a big mistake, so let’s take a look at the various aspects that make HSAs a great tool for saving and paying for health care expenses as a young professional.
An Overview of Health Savings Accounts
Health Savings Accounts came into existence in 2003 with the Medicare Modernization Act signed by former President George W. Bush. These accounts are tax-advantaged medical savings accounts available to individuals and families that enroll in a high-deductible health plan (more on this below). The money contributed to a HSA can be used to cover qualified medical expenses as they arise throughout the year or in the future. In fact, many HSA providers offer debit cards, which make it incredibly easy to utilize the money as expenses arise.
Another perk of HSAs is contributed dollars are not use-it-or-lose-it vehicles, like Flexible Savings Accounts (FSA, another form of medical savings account) where any money that is not used by year end is forfeited. HSAs are also owned by the individual unlike Health Reimbursement Arrangement (HRA), which means the HSA is portable regardless of your employment situation.
The Tax-Advantaged Triple Play
Unlike virtually every other savings vehicle, HSAs have a triple-tax benefit. With a Roth IRA or 401(k), money is taxed up-front, while future withdrawals are tax-free after age 59.5. Conversely, a traditional IRA or traditional 401(k), allows for no tax to be paid up-front, also known as tax-deductible, while taxes are owed upon withdrawal in the future. Both traditional and Roth accounts are also tax-deferred meaning any investment growth or dividends are not taxed until distribution.
In contrast, HSAs receive a tax-free triple play, where contributions to HSAs are tax-deductible (made with pre-tax money), any growth or interest is tax-deferred, and any withdrawals to pay for qualified medical expenses are tax-free upon distribution.
Important Health Savings Account Rules
With all of the advantages of HSAs, especially for young professionals, it’s important to keep in mind a few important rules before taking full advantage of these vehicles. First and foremost, only individuals and families that have a High-Deductible Health Plan (HDHP) are eligible to make contributions to an HSA. This requires that deductibles on health insurance plans meet a minimum threshold of $1,300 for individuals or $2,600 for families in 2016. Some employer sponsored health plans do not offer a HDHP, in which case using a HSA is not an option.
It’s also important to keep in mind the various contribution limits. In 2016, individuals can contribute $3,350, while families can contribute $6,750. Keep in mind that contributions can be made up until the tax deadline, which means you would have up until April 15, 2017 to make a 2016 HSA contribution. As a quick rule of thumb, if you’re a family in the 33% tax bracket by contributing to a HSA, you would lower your tax bill by $2,227 by maxing out your HSA.
The last thing to keep in mind when it comes to HSAs is that they are—like many retirement accounts—penalized if you take a non qualified distribution. As discussed above, any withdrawals are tax-free if for qualified medical expenses like over-the-counter drugs or other medical expenses. However, if withdrawals are taken to cover travel or some other non-medical expense, a 20% penalty will be assessed, plus all money withdrawn will be taxable. The one caveat to that rule is that upon turning 65—which is likely a decades away for anyone reading this—the 20% rule is eliminated and the HSA begins to function much like a traditional IRA.
What to Watch For with Health Savings Accounts
In recent years, research has increasingly supported the idea that HSAs might be the best all-around savings vehicle out there given the high cost of medical expenses in retirement. Some have even suggested the individuals should max out a HSA before contributing to a 401(k) plan with a match. While this decision is an incredibly personal one that relies on tax rates, employer match amount, and other information, it does further emphasize the value of contributing to a HSA.
With all that said, however, it is critically important to watch out for a number of things when it comes to utilizing HSAs. First and foremost, it is critical to fully understand any of the fees associated with your HSA account. Increasing regulation is requiring more and more transparency surrounding fees in 401(k) plans, but those rules have not yet made their way to the world of HSAs. The takeaway? Be sure to ask to see a full breakdown of any and all fees with the account. These can include a check writing fee, a monthly account fee and other transaction fees.
Lastly, have a good understanding of the flexibility a provider offers when it comes to your saving and investment options. Many providers will allow accountholders to invest HSA dollars once an account gets over a certain level, while some providers may limit you to a more traditional savings account—and the measly return that comes with it.
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