Health savings accounts (HSAs) provide potent tax advantages to people saving for future medical expenses. HSAs are also portable if you change jobs and unused funds roll over at the end of the year. However, HSAs require participating in high deductible health plan (HDHP), which exposes savers to potentially high medical bills. They can only be used for qualifying medical expenses, and violations of that rule can mean steep penalties.
A financial advisor could help you put a financial plan together for your healthcare needs and goals in retirement.
HSA Basics
HSAs are special trust accounts people can use to save to cover future medical costs. They are heavily tax advantaged. Contributions by employees or employers can be deducted from current income, gains from interest or investments grow un-taxed and later withdrawals are also tax-free if used for qualifying medical expenses.
HSAs are only available to people covered by high-deductible health plans (HDHPs.) The minimum size of this deductible changes periodically. For 2022, qualifying HDHPs must have minimum deductibles for $1,400 for individuals and $2,800 for families. Maximum out-of-pocket expenses including the deductible can be as high as $7,050 for individuals and $14,100 for families.
HSA Pros
Tax advantages represent the biggest draw. Contributions by employees, employers and family members do not count as currently taxable income for federal income tax purposes. And that includes FICA taxes as well as federal income taxes. That gives HSA savers immediate tax savings. And taxpayers can claim HSA contributions as deductions even if they don’t itemize on their returns.
Tax-free growth means interest and other gains on the funds in an HSA are also free of federal income taxes. And tax-free withdrawals savers take out the money to pay qualified medical expenses without, again, incurring any federal income tax.
HSAs belong to the employee and can be kept through any number of job changes. The amounts aren’t forfeited if not used in any year, and continue to mount through paycheck deductions and investments gains.
Also, HSAs aren’t subject to Required Minimum Distributions. That means retirees don’t have to take funds out of their HSAs unless they have qualified medical expenses they wan to pay for
HDHPs charge lower premiums than more standard plans with lower deductibles. Pairing an HSA with an HDHPs offers a money-saving potential combination of low insurance costs with tax benefits that are unmatched by any other savings vehicle.
HSA Cons
The big drawback of an HSA is that you have to sign up with a high deductible health plan to be eligible for one. It is difficult to forecast medical expenses accurately. So a family hit with a surprise medical expenses could have to spend as much as $14,100 in out-of-pocket costs in a single year before the insurance starts paying those costs.
Tax-free HSA withdrawals can be made only for qualified medical expenses, which include costs incurred to treat or avoid illness. That covers expenses such as doctor bills, prescription medications and lab test as well as insurance copays and co-insurance. However, it doesn’t cover other health-related costs such as gym memberships and cosmetic surgery.
If withdrawals are used to pay for non-qualified expenses, the IRS will levy 20% penalty on those amounts. In addition the withdrawals will be taxes as ordinary income. HSA users may have to keep detailed records showing withdrawals were used for qualified expenses, or risk these penalties.
Other considerations include the fees that HSAs charge. While these can add up over time, they are generally much less than the potential savings on taxes that HSAs offer.
Another limitation is that people who are covered by Medicare, which includes most people over age 65, cannot make contributions to their HSAs, although they can keep them and use them to pay future medical costs.
Finally, some states do not exempt HSA contributions from state income taxes. So while an HSA can save on federal income taxes, it may not help with state taxes.
Bottom Line
HSAs present nearly unmatched tax advantages over other savings tools, and can help significantly to pay for future medical costs. They are portable, don’t expire and can be used to pay for many health-related expenditures. However, to get one people have to join high-deductible health plans that expose them to potentially steep healthcare bills. And should withdrawals be used to pay for anything other than qualified health costs, the penalties are severe.
Tips on Paying for Healthcare
- A financial advisor can help you put a financial plan into action for your healthcare needs. Finding a qualified financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- HSAs are generally seen as most attractive for younger, healthier people who don’t spend a lot on healthcare. Older people and those with chronic conditions that result in large health costs may be better off with traditional insurance that has no HSA but a lower deductible.
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