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Health Savings Accounts are funded with pre-tax dollars, grow tax-free, and then, if withdrawn for approved medical expenses, are withdrawn tax-free.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.
- For young adults: A savvy planning strategy if you are no longer a dependent, are in a high-deductible health insurance plan, and have debt under control or zeroed out, is to fund your employer-sponsored retirement savings plan just up to the employer-match, fully fund a Roth IRA, and then put remaining cash into a health savings account. NOTE: A key assumption here is that you already have sufficient cash reserves for emergencies and an action plan in place for gathering cash reserves for such intermediate term goals as purchasing a new home or starting a family.
- For the parents of young adults: If your child is no longer your dependent and is covered by your high-deductible health insurance plan, they are eligible to open and fund their own health savings account. NOTE: They are no longer eligible to receive benefits from your health savings account.
- For mid-career workers: Follow the advice for young adults—but then circle back to your employer-sponsored retirement plan. If it has appealing low-cost investment options, direct additional savings up to the IRS allowed amounts, perhaps directing employee contributions to the Roth option. Then, direct further savings to a taxable account and/or aggressive mortgage prepayments. Aim to keep boosting your savings rate to at least 20% as income rises over time.
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:
- Prescription drug costs
- Dental fees
- Lab fees
- Health insurance premiums if you are collecting unemployment benefits or paying COBRA premiums
- Medicare (but not Medigap) premiums for you and your spouse if you, the owner of the account, are at least age 65
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.
- For those who retire before age 70: If you retire before age 70 and plan to make taxable withdrawals from retirement accounts and not draw on Social Security benefits to fund daily expenses, consider minimizing those taxable retirement account withdrawals by paying health expenses with cash from your health savings account. Doing so will allow more room for possible Roth conversions before the river of taxable income starts at age 70 from both Social Security payments and required distributions from retirement accounts. Health savings accounts can help postpone Social Security benefits until those benefits are maximized at age 70.
- For those who are in between jobs: If you are in between jobs, it is likely that personal cash flow is tight. Use cash from the health savings account to pay current health care expenses. Health savings accounts are like a rainy-day fund. If you are unemployed and cash is tight, it’s raining.
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
- the deductible must be at least $1,350 for individuals and $2,700 for families,
- out-of-pocket costs (importantly, excluding out-of-network costs) are capped at not more than $6,650 for individuals and $13,300 for families, and
- there is no coverage for anything beyond preventive care before the deductible is met.
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.
- If you can’t figure out if your coverage is high-deductible: Most people simply ask their employer which, if any, of the offered plans are high-deductible plans for the purpose of qualifying for a health savings account.
- If out-of-network care is important to you: If you anticipate a need, or if it is simply a high value to you, to be able to go out of network for care, then a high-deductible plan may not be the right choice for you. Choose the right health insurance plan first, then decide whether or not to fund a health savings account.
- If your spouse has employee benefits: Be aware that you are ineligible for contributing to a health savings account if your spouse has opted in to a flexible savings account or has an active health care reimbursement account that pays for any expenses before your high-deductible plan deductible is met. (NOTE: A rule-laden exception to the prohibition of funding both a health savings account and a flexible spending account in the same year is when your employer offers a ‘limited purpose’ flexible spending account that can only be used for dental and vision benefits.)
- If you have a flexible spending account: If you have a flexible spending account this year and want to contribute to a health savings account next year, be sure to bring your flexible spending account to zero before year-end. A positive balance in your flexible spending account at this year-end will make you ineligible to contribute to a health savings account next year. The flexible spending account grace period of being able to pay expenses 2 ½-months subsequent to year-end taints your ability to contribute to the health savings account.
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.
- If you and your spouse are eligible to make a catch-up contribution: While you can have a family health savings account, IRS rules prohibit putting two catch-up contributions into one “family” account. To capture two catch-up contributions, each spouse needs to have an individual account.
- If you have significant wealth and significant distaste for administrative hassle: You might reasonably conclude that having a health savings account is more trouble than it is worth to you. Sometimes the strongest argument for a high-net-worth investor to have a health savings account is the potential tax planning flexibility it might give, e.g. of having a non-taxable source of funds to draw upon when minimizing taxable income for tax planning purposes is a front-burner goal in a particular year. But the hassle factor of health savings accounts is real and if the anticipated balance in your health savings account is small relative to your net worth, you can reasonably pass on the opportunity.
- If personal cash flow is tight: When unexpected healthcare costs arise, you may not have enough money saved in your health savings account to cover expenses. For some families, it can also be difficult to come up with the cash to meet a high-deductible, especially for families with young children or a history of high medical bills. You may also be reluctant to seek health care when you are sick because you don’t want to use funds in the health savings account. If you find yourself in one of these circumstances, a health savings account may not be right for you.
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.
- Beneficiary designations matter: Keep the beneficiary of your health savings account up to date and if your beneficiary is not your spouse, give careful thought and planning to end-of-life tax planning for your health savings account. It may not be tax-smart to die with a balance in your health savings account.
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.
- Consider these key general factors: In general, you want to keep fees and administrative hassle minimized by choosing as few low-cost funds as possible and by periodically consolidating accounts to one custodian. Because of the rapidly evolving state of the industry, savvy shoppers will buff up their knowledge of industry options every few years.
- Tailor coverage to your situation: Some health savings accounts are particularly good for those who anticipate letting their balances grow undisturbed by withdrawals for many years. In those accounts, the quality and costs of investment options are key. For those who need their health savings account to be at the ready for a more current, unexpected expense, the safety and liquidity of the account, and securing low transaction and monthly fees will be the important factors.
- Be a savvy user of web-based comparative sites: Don’t just look at the reported average cost of each health savings account. Figure out what you can do with the available investment options. Such an approach works well with some of the larger and more common plans such as Optum. As an example, Optum’s average portfolio as described by some web services is expensive. But you can assemble an excellent low-cost and diversified portfolio at Optum by carefully choosing among their various investment options. Look under the hood.
- Consider what you want from your advisor: At this point in industry development, there are some account custodians who collaborate well with advisors, e.g. Health Savings Administrators, but sometimes at the cost of somewhat higher fees than a custodian such as Health Equity where there is an appealing line up of low-cost investments but no view-only access for your advisor. The more direct (and safely view-only) access your advisor has to your accounts, the more administrative hassle your advisor can lift off you.
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.