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Is a Health Savings Account Right for You? 🤔

February 1, 2022

Guest post by Dr. Barbara O’Neill, CFP®, AFC®

Tax-deferred 403(b) plans are not the only way for educators to build wealth. Some are also using health savings accounts (HSAs), which are tax-advantaged accounts designated for health care expenses. HSAs share several common features with individual retirement accounts (IRAs): pre-tax (i.e., money that is not taxed) contributions (traditional IRAs) and tax-free withdrawals (Roth IRAs).

While all wage earners are eligible to contribute to IRAs, only those with a high-deductible health plan (HDHP) are eligible to contribute to HSAs. In the past decade, however, that share of workers has increased dramatically. In 2019, 51% of the U.S. workforce was enrolled in a HDHP. A quarter of large employers offer only a HDHP with an HSA option.

This post describes HDHPs and HSAs and IRS tax regulations with respect to HSAs. There is also a math illustration to compare HDHP coverage with that of a low-deductible policy. It then discusses how to establish HSAs, how they are impacted by life events, and research findings about HSAs as a wealth-building tool. It concludes with six take-away action steps.

HDHP Highlights

HDHPs are a pre-requisite for HSA eligibility. Each year, a minimum annual deductible amount is indexed for inflation.  In 2022, the minimum HDHP deductibles for HSA-qualified plans are $1,400 for self-only coverage and $2,800 for family coverage.

Some employers offer their workers a choice of health care plans: higher premium policies with lower deductibles and lower premium policies with higher deductibles. Others offer only one type of plan.

HDHPs have advantages and disadvantages. On the plus side, they generally have lower premiums- 36% cheaper- than low-deductible policies. ValuePenguin reported an average annual cost for HDHPs of $4,971 vs. $7,816 for low-deductible plans, a $2,845 difference! Another advantage is access to HSAs.

The biggest disadvantage of HDHPs is paying more money out-of-pocket before benefits begin. This can be a serious financial drain if someone incurs costly medical bills or develops a chronic illness (e.g., diabetes).  The 2022 annual maximum limit on out-of-pocket expenses (e.g., copayments and deductibles) is $7,050 (self-only) and $14,100 (family). These numbers do not include policy premiums.

Another downside of HDHPs is a documented tendency for some policyholders to forgo health care services to save money. This often makes medical conditions worse when left untreated.

HSA Highlights

HSAs are tax-exempt accounts designed to pay qualified medical expenses. They can also be a “back-door” retirement account because money can be withdrawn for non-medical purposes once someone reaches age 65 without paying the 20% penalty for non-qualified withdrawals that younger taxpayers must pay. Nonmedical withdrawals are taxed as ordinary income just like traditional IRA withdrawals.

Workers with HDHPs can establish HSAs. New contributions must end once they enroll in Medicare. Unlike flexible spending accounts (FSAs), HSA deposits do not need to be spent down annually. Instead, funds can accrue over time. Contribution limits for 2022 are $3,650 (self-only) and $7,300 (family) with a $1,000 catch-up contribution available for workers age 55 and older.

Other things to know about HSAs are that policyholders cannot also be covered by a low-deductible plan (e.g., parent or spouse plan) and that qualified medical expenses for HSAs are generally the same as those that qualify for the medical expense itemized deduction on tax returns. In addition, someone has until April 15 of the following year to make HSA contributions for the previous year. HSA owners can also have an IRA, a 403(b), and a defined benefit pension.

Tax Topics

When tax rules are followed, HSAs are triple tax-advantaged; i.e., no tax on deposits, account earnings, or withdrawals. Account owners can either contribute pre-tax dollars via payroll deduction (like 403(b) contributions) or claim an “above the line” deduction (used to determine adjusted gross income) on their federal tax return for deposits made with after-tax dollars. Either way, IRS Form 8889 is required.

Unlike tax deductions for medical expenses, which require the ability to itemize, the deduction for HSA contributions is available to all eligible taxpayers, whether they take the standard deduction or itemize.

If employers contribute to a worker’s HSA, this money is not taxable to employees.

Insurance (Math) Illustration

The big unknown with HDHPs is future health care expenses. In other words, will the cost of medical expenses exceed premium savings versus a low-deductible plan? Nobody has a crystal ball, but they do have a health history. People with disabilities and chronic conditions may do better not electing a HDHP, which would make them ineligible for HSAs.

“Doing the math” with plan-specific data and hypothetical cost-benefit scenarios can help inform decisions about whether a HDHP or a low-deductible plan is best. Co-insurance costs are excluded for simplicity in the examples below.

Example: Let’s assume $6,000 in annual medical expenses, a $2,000 difference in policy premium costs, and a $3,000 difference in the deductible between a HDHP and low-deductible policy.

Policy Feature

HDHP

Low-Deductible Plan

Annual Premium

$2,500

$4,500

Policy Deductible

$6,000

$3,000

Medical Expenses

$6,000

$6,000

Total Cost (Premium + Deductible)

$8,500

$7,500

In this scenario, the low-deductible plan would pay half ($3,000) of the medical expenses, saving $1,000 overall. However, if medical expenses were only $2,000, the situation would be reversed and the HDHP would save $2,000.

Policy Feature

HDHP

Low-Deductible Plan

Annual Premium

$2,500

$4,500

Policy Deductible

$6,000

$3,000

Medical Expenses

$2,000

$2,000

Total Cost (Premium + Deductible)

$4,500

$6,500

Purchasing Process

Employers often select HSA providers for their HDHPs. Like 403(b) plans, employees are provided with a menu of investment choices to select from. In other cases, employees need to open HSAs on their own with a financial institution that administers HSAs. A good source of information is the Health Savings Administrators website. Investopedia also has information about HSA providers.

Special prorated HSA purchasing rules are in effect for workers who do not have qualifying HDHP coverage for an entire year.

Life Events

Sometimes “life happens” and there are special HSA rules to deal with them:

  • Job Change/Unemployment/Retirement- HSAs are portable upon a change of employment. If someone meets IRS eligibility rules (e.g., a new HDHP), they can continue making contributions. Otherwise, funds can continue to grow until needed. Check with your employer or account custodian for plan specifics regarding account transfers.
  • Death- HSAs with a spouse named as beneficiary treat the survivor spouse as the new account owner. If anyone else is named, the account is no longer deemed an HSA and taxes are due in the year of the deceased owner’s death. An exception applies for funds used for the decedent’s medical expenses.
  • Divorce- HSAs can be transferred to a former spouse as part of a divorce settlement. The account transfer is non-taxable and the ex-spouse becomes the account beneficiary. Seek legal advice.

Research Results

Studies indicate that HSAs are concentrated among high-income households, older taxpayers, and large employers. Many healthy individuals are likely using HSAs to save for nonmedical expenses in later life. Research also indicates that about a third of U.S. adults enrolled in a HDHP did not have an HSA and more than half of those with HSAs had not contributed any money during the past year.

An award-winning study ranked contributions to an HSA as a higher priority to increase wealth than making deposits to garner employer match in a 401(k) for many workers. Some 403(b) plan participants also get match and might find the suggested action step hierarchy useful: 1. maximum HSA contribution, 2. amount to get maximum employer match, 3. high-interest rate debt, 4. college 529 plan, if there is state tax savings, 5. unmatched retirement plan contributions, and 6. taxable (non-retirement) accounts.

Three (More) Things

  • A common error is HSA contributions made after participants enroll in Medicare. In this case, excess contributions (and their earnings) can be withdrawn penalty-free before the tax filing date.
  • HSA funds cannot be used to pay an adult child’s medical expenses unless the child is considered a dependent.
  • Taxpayers cannot claim an itemized deduction for medical expenses paid with HSA dollars. In addition, workers can’t contribute to HSAs and FSAs in the same year.

Six Smart Strategies

No. 1: Evaluate Your Savings — Calculate your net worth (assets minus debts) and determine whether you have the financial resources necessary to pay a large HDHP deductible for one or more years. If not, beef up your emergency reserves.

No. 2: Answer This Question Honestly — Answer yes or no…would a medical bill for you or a family member that involves a large out-of-pocket cash outlay cause you to skip or delay medical treatment? If so, you might want to reconsider a HDHP and forgo an HSA….or aggressively fund an HSA to provide the necessary funding.

No. 3: Consider Your Health Status — Incorporate disabilities and chronic conditions, family health history, personal health history, and other risk factors for illness or injury (e.g., risky sports and long commutes) in your decision-making.

No. 4: Review HSA Investment Menus — Check with the HSA plan administrator to learn about available investment options, just as you would with a 403(b) plan. For example, there may be a menu of mutual funds to select from. Look for investments that have good performance and low expenses.

No. 5: Plan to Build Wealth — Use an online calculator to determine how much you could potentially save. Of course, nobody knows their future health status and whether an HSA will be needed for medical expenses. If you are lucky (no accidents), have good health habits, and incur modest medical bills, HSAs can be saved instead of spent.

No. 6: Get Help When Needed — Check with your HSA administrator for plan-specific enrollment and investment selection details and IRS Publication 969 for tax-specific information.

In Summary

HDHPs may be one of several health insurance options available to you or the only option. Either way, it is important to understand how they work.

If you have access to a HDHP, take the time to learn more about HSAs. Not only can HSAs pay medical bills, but they can also build wealth over time and reduce income taxes.

This post provides general personal finance information and does not address all the variables that apply to an individual’s unique situation. It should not be construed as legal or financial advice. If professional assistance is required, the services of a competent professional should be sought.

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Dr. O'Neill is the owner/CEO of Money Talk: Financial Planning Seminars and Publications where she writes, speaks, and reviews content about personal finance. She is a Distinguished Professor Emeritus at Rutgers University and a long-time 403(b) plan participant.

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