An inability to pay medical bills is the single greatest cause of personal bankruptcies in the United States. While this result may not be surprising since the American health care system is the most expensive in the world, the study paradoxically found that three-quarters of the people filing a medically-related bankruptcy have health insurance. According to Steffie Woolhandler, M.D. of Harvard Medical School, “Many of them were bankrupted anyway because they had gaps in their coverage, like co-payments, deductibles, and uncovered services.”
Due to the continued increase in the cost of insurance premiums, employers are transferring a rising percentage of the cost of health insurance to their employees by raising the employee’s share of premiums, increasing co-payments and deductibles, and restricting access to specific providers. In fact, the passage of the Patient Protection and Affordable Care Act may accelerate this process. Barron’s, a leading business and financial publication, declared that the impact of the law will be “a new wave of rising prices or a rationing of medical care – or both.”
Considering the dire predictions, an HSA may help you to best afford and adequately protect yourself and your family from a devastating medical event.
What Is an HSA?
An HSA, short for Health savings account, is the combination of a high deductible health insurance policy and a tax-advantaged savings account. It is increasingly the strategy of choice for astute consumers seeking to minimize out-of-pocket costs for medical care while ensuring financial protection from a health-related catastrophe. The savings account is used to pay medical costs until the deductible limit of the insurance policy is reached, at which point the insurance coverage kicks in to cover additional expenses.
Under federal tax law, filers cannot itemize and deduct medical expenses unless the medical expenses exceed 7.5% of gross income, not including health insurance premiums. For most filers, this requirement effectively means they cannot deduct any medical expenses from their gross incomes; therefore, all medical costs are paid with after-tax dollars.
Contributions to the HSA are deductible and, while qualified expenses paid by the HSA are reported, the payments are not attributed as income to the taxpayer. Practically speaking, this means that the 7.5% of gross income requirement is eliminated for those people with an HSA.
The tax-advantaged HSA was created under Title XII of the 2003 Medicare Prescription Drug, Improvement and Modernization Act and is modeled after an earlier successful IRS pilot program, the Archer Medical Savings Account, which had been limited to the self-employed and small businesses with less than 50 employees.
Health savings accounts are similar to the popular individual retirement accounts (IRA) established in 1974 to encourage and assist people to save for their retirement years. HSAs are intended to help people cover their immediate and future medical expenses.
The similarities between the two types of accounts include:
- Tax-Deductible Contributions. Annual contributions into a HSA are deductible from your gross income for federal income tax purposes. Contributions up to $3,100 per individual (or $6,250 if you have a family high deductible health plan) are deductible in the HSA. If you’re over 55 when you set up the account initially, you can “catch up” by increasing your deductible amount by $1,000 each year until you reach age 65.
- Tax-Free Growth for Future Medical Expense. Unlike Flexible Savings Accounts, any funds remaining in the HSA at the end of the year “roll over” to the following year without penalty. There are no taxes due as long as withdrawals are used to pay qualified medical expenses. These expenses can range from acupuncture to long-term care insurance premiums. A complete list of eligible expenses can be reviewed in IRS Publication 502 on medical and dental expenses. There is no limit to the fund balance, which can be accumulated over the account’s life. Upon the insured’s death, the ownership of the fund transfers to a named beneficiary surviving spouse or to the estate of the insured. In the former case, there is no taxable event until funds are withdrawn, the corpus of the account simply becoming the HSA of the spouse. If there is no surviving spouse, the untaxed growth is taxed at the decedent’s normal rate.
- Tax-Deferred Growth for Non-Medical Expenses. Funds deposited into the HSA can be withdrawn at any time. However, funds withdrawn before age 65 and not used for qualified medical expenses are taxed at ordinary income tax rates plus a 10% penalty. After age 65, withdrawals for non-medical expenses are taxed at ordinary tax rates without the penalty, similar to the treatment accorded to the very popular IRAs used by many to build retirement funds.
- Investment Flexibility. Like an IRA, eligible investments in an HSA include stocks, bonds, mutual funds, savings accounts, and other investments depending upon the options allowed by the HSA administrator with whom you choose to work with. In addition, each HSA administrator typically provides a range of different account services including special checking accounts, debit cards, and electronic bill payment.
- Portability. Unlike many employment benefits, you own the HSA, which remains intact whether or not you remain with the same employer, replace account administrators, alter your investment strategy or choices, or change your insurer provided that the policy continues to qualify as a high deductible health insurance policy. At death, the account automatically becomes the property of your spouse and can be used for similar purposes without any penalty or tax.
As with most financial and insurance products, it is likely that you will incur an initial expense to establish the HSA, annual maintenance fees while the account is open, and possibly commissions each time you buy or sell assets within the HSA. For the most part, these fees are comparable to or less than you would pay to establish and maintain an IRA or 401k retirement account. My research indicates that the initial set-up fee is likely less than $75 with annual maintenance fees between $25 and $75 thereafter. If your account balances grows significantly over the years, your fees will see a similar increase.
HSAs are highly regulated instruments, and are offered by the largest, most reputable insurance firms and banks in the United States. As a consequence, you should easily see and understand the initial and any subsequent or ongoing administrative fees that apply to your account.
Who Can Establish an HSA?
Today, anyone who is insured under a high deductible health plan can establish an HSA, whether or not the policy premiums are paid by an individual, a spouse, or an employer. Under current rules, the policy must require that the insured pay initial medical costs (the deductible) before the insurance company is liable for any expense, and the minimum deductible required is $1,200 for an individual or $2,400 for a family.
The maximum out-of-pocket liability of the insured for health expenses is limited to $6,050 and $12,100 for individuals and families, respectively. The higher deductible translates into a lower premium for insurance coverage, as the insurance company is less likely to be liable for a significant health expense for the insured person or their family during the coverage period. The reduced risk translates into lower premiums for the insured policyholders.
However, when choosing a high deductible plan, be aware that while most health insurers offer high deductible policies, not all such policies are qualified to be HSA plans. The insurer must agree to federal reporting requirements and comply with the state’s insurance laws, as well as meet the necessary requirements.
People Best Suited for a HSA
The higher your taxable income, the greater the tax benefits you can receive by establishing an HSA. However, replacing a low deductible health insurance policy with a high deductible policy and a HSA makes sense for you if you fit either situation:
- The new share of your premiums will be less than the increase in the new deductible. For example, if you save $3,000 in premiums by increasing your deductible by $3,000 or less, you would be well advised to consider the HSA.
- Out-of-pocket medical expenses are significant, but less than 7.5% of your adjusted gross income since the IRS does not allow you to itemize or deduct medical costs below that threshold. Using an HSA means that your medical expenses are paid with pre-tax dollars, saving you a minimum of $840 if you’re in the 28% tax bracket.
Some people elect to establish an HSA simply as a supplemental retirement account where investments can accumulate tax-free until withdrawn, similar to an IRA. When the owner of the account reaches retirement (age 65), the accumulated funds in the HSA can be withdrawn and used for any purpose without penalty. Many financial advisers have developed exotic, though effective strategies to maximize retirement income from combined Social Security payments and private accounts such as IRAs, HSAs, and 401ks.
Before electing a withdrawal strategy, you should seek counsel from a competent financial advisor to be sure it fits your personal situation and goals.
Some health professionals are concerned that individuals who purchase HSAs – specifically the associated high-deductible health insurance policies – might be reluctant to seek needed medical advice or regular medical check-ups in order to save money.
“As any doctor will tell you, small health problems left untreated can become big problems,” warns Kathleen Stoll, director of health policy at the health care advocacy group Families USA. “This is just one of the many high-deductible pitfalls consumers need to watch out for.” It should be apparent that good health always trumps money in the bank.
How to Set Up an HSA
If you’ve decided that an HSA is the proper investment or health insurance vehicle for you, setting up an account is easy. Virtually all of the major health insurers offer high deductible health insurance in group and individual policies. Many insurers also offer HSA administrative services. In addition, there is a wide variety of third party administrators for HSAs, including most major banks and financial institutions, each with unique fees which may be charged and investment options available for the fund balances.
Take the time to investigate several of the administrators to determine which one is best for you. Once you’ve made your decision, actually establishing the account can be easily and quickly accomplished online.
Follow these steps:
- Get Insurance Quotes. Acquire quotes from the major health insurers in your state by phone or over the Internet. Then, select the insurer and policy that best fits your needs. Many insurers have an affiliate or subsidiary company, or will recommend a company which can establish and administer an HSA at the time you purchase your health insurance. Administrative fees for set-up typically run less than 1%
- Select an HSA Administrator. If you prefer to utilize a non-insurer administrator, there are a number of major banks and financial entities that offer HSA accounts and hope to help you with the investments within the account.
- Fund Your Account and Invest the Funds. When you establish the HSA, the administrator gives you directions on how to make deposits and withdrawals from the fund balance and the process whereby you can change investments. In most cases, you receive either a debit card or special checks tied to the HSA to facilitate record keeping; you also receive monthly or quarterly statements regarding the fund’s investments and balances.
As people age, the proportion of their income devoted to maintaining health increases – and few are able to avoid a costly medical event throughout their lives. Establishing an HSA account allows you to fund for the possibility of an unexpected medical cost while preserving your option to spend the savings for other purposes when you’re older. An HSA is a true example of the oxymoron – having your cake and eating it too.
What additional tips can you suggest for setting up an HSA?