Health Savings Accounts: Pros and Cons & Planning Tips

If you are in a high-deductible health insurance plan, are looking for a powerfully tax-efficient savings vehicle, are not claimed as a dependent on someone else’s tax return or covered by any other health plan and have time for personal wealth to compound over time, then yes, opening a health savings account could be a potential gem for your finances.

Think also of your children. If you have non-dependent adult children, they might also be eligible for a Health Savings Account. Helping a young adult open and fund a health saving account could be a wonderful financial gift of both financial literacy and financial strength.

What’s the big deal about health savings accounts?

Health savings accounts are triple tax efficient

Health Savings Accounts are funded with pre-tax dollars, grow tax-free, and then, if withdrawn for approved medical expenses, are withdrawn tax-free. Wow. A triple header. However, there is an IRS annual limit of what you can contribute, currently (2018) $3,450 for singles and $6,750 for families, plus an extra $1,000 per year catch-up contribution starting when the owner turns 55.

Although the annual allowed amounts are not large, even these limited contributions become highly valuable as they compound over time. Mid-career workers and young adults who are no longer dependents of their parents are obvious candidates for opening a health savings account, because they are looking for savings opportunities and they have time to allow the miracle of compounding to help grow their savings.

Planning tips:

Health savings accounts help pay for unreimbursed medical expenses

Just as with daily expenses in retirement, you are increasingly on your own when it comes to figuring out how to pay for unreimbursed medical expenses.  Adding salt to the wound, such expenses are growing as more of the burden of health care expense is shifted to patients.

Expenses that you can pay with funds from your health savings account include such costs as:

Having a substantial, tax-efficient fund at the ready in retirement to help pay these expected costs is a welcome financial safety net. Be aware, however, that if you draw from your health savings account for ineligible expenses before age 65, you will pay regular taxes plus a 20% tax penalty on the withdrawal. After age 65, or in the event of death or disability of the owner, the 20% penalty tax for using funds from a health savings account is no longer imposed.

Planning tips:

Additional terrific features

Health savings accounts are fully portable.  They stick with you regardless of changes in employment including retirement, changes in residency and marital status. You can draw funds from your health savings account for your spouse and children as well as for yourself, even if your spouse or children are no longer in a high-deductible health insurance plan themselves as long as, in the case of your child, your child is your dependent. Plus, anyone can fund contributions, including for example, employers, parents, and grandparents.

But health savings accounts only work if you are in a high-deductible health plan

In 2018, to be a high-deductible health insurance plan, the IRS requires that

Whether to opt into a high-deductible plan is a potentially consequential personal decision.  Check the details of the plans available to you.  The typical high-deductible plan includes strong financial incentives for in-network care, making going out-of-network for care very expensive.

Planning tips:

Contributing to a Health Savings Account

Payroll deductions are advantageous: Health savings account contributions made through payroll deduction are not subject to payroll taxes, Federal Tax or Federal Unemployment Act withholding. In contrast, pre-tax contributions to retirement savings plan are subject to payroll taxes. Some employers make a financial contribution to employee health savings accounts in addition to simply offering the payroll deduction benefit.

Payment schedules for health savings accounts are flexible: You can make monthly contributions or lump-sum contributions anytime until your tax filing date for the year, typically April 15th of the following year. (In contrast, contributions to flexible savings account must be made during the calendar year in regular monthly contributions according to benefit election choices you made during the benefit open enrollment season, typically during the fourth quarter of the preceding year. However, once you enroll in Medicare, further contributions are not allowed to health savings accounts.

Eligibility rules are complex:  There is something called the Last Month Rule.  If you are eligible to participate in a health savings account on the first day of the last month of the tax year (typically December 1st), you are deemed to be eligible for the entire year. However, if you become ineligible at any time during the Testing Period (the twelve months subsequent to (the typically) December 1st beginning date, then there are recapture rules. Any contribution that was taken as pre-tax because of the Last Month Rule becomes taxable in the year you became ineligible with an additional 10% penalty.

Contributions (and withdrawals) are reported on your annual tax return: Your employer will report employer contributions on Form 5498 and will also include a total dollar amount on Box 12 of your annual Form W-2 for total payroll deductions. Contributions that you make personally, not through payroll deduction, are noted on the first page of your tax return as an above the line deduction. You report the details of your personal contributions and withdrawal information on Form 8889 included as an attachment to your tax return.  NOTE: There will be a separate Form 8889 for each of your health savings accounts with the word ‘statement’ written at the top, plus a summary Form 8889 that consolidates data from each statement Form 8889. If you happen to contribute more than the allowed amount, there is a process, much like the process for excess IRA contributions, that you can follow to reverse the excess contribution.

Planning tips:

What happens at the death of the owner of a health savings account?

Health savings accounts are beneficiary accounts.  If the spouse is the beneficiary, the health savings account continues with the spouse as the new owner. In contrast, if the beneficiary is a non-spouse, including a trust, the account ceases to be a health savings account at the death of the owner and the fair market value becomes fully taxable to the beneficiary in the year of the death. An exception is that there is no taxation to the extent that the beneficiary uses health savings account within one year of the date of death to pay eligible medical expenses of the decedent.

Planning tip:

How to shop for a health savings account

The health savings account industry is growing rapidly which means the mechanisms for comparing plan features and costs efficiently are also evolving.  Plus, the industry will undoubtedly improve their offerings as competitive pressures increase from the actions of attentive consumers.  In the meantime, a useful site for exploring various custodian offerings is thehsareportcard.com.

Planning tips:

To conclude, are health savings accounts the best thing since sliced bread?  For some investors, yes.  But make sure you are one of those investors before plunging in.

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