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What Is a Health Savings Account (HSA) – Rules, Limits & How to Open

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Medical expenses are the single greatest cause of personal bankruptcies in the United States, according to a study published in the American Journal of Public Health in 2019. Even scarier, most of those bankruptcy filers carried health insurance.

Health care costs continue to rise faster than both wages and inflation. In 2019, the Kaiser Family Foundation reported that the average health insurance premium for families with employer-sponsored health insurance surpassed $20,000 for the first time, reaching a dizzying $20,576 per year.

These unaffordable premiums have forced many Americans to look for more affordable options wherever they can find them. Often, lowering your premium means raising your deductible.

That raises a problem for many Americans, who don’t have enough money set aside in savings to cover high deductibles. If your health insurance deductible is $5,000, and you face an expensive medical emergency, you need to come up with the first $5,000 in cash on your own before your insurance pays a cent. For the median American who only has $4,500 in their savings account, that can be a real challenge.

Lawmakers saw this issue coming and asked the question: How do we incentivize people with high-deductible health plans to set aside more money for medical expenses? Their answer was the health savings account, or HSA.

Overview: How HSAs Work

Think of HSAs like individual retirement accounts (IRAs) for medical expenses.

To cover increasingly high deductibles, Congress allows you to set aside money tax-free in a health savings account. You can tap your HSA to pay medical costs until you reach the deductible threshold, at which point the insurance coverage kicks in to cover additional expenses.

In order to qualify for an HSA, you must have a high-deductible health plan (HDHP). Higher deductibles translate to a lower premium for insurance coverage, as the insurance company is less likely to pay out any claims in any given year. As with all insurance, lower risk for the insurer means lower premiums for the customer.

As the name suggests, a high-deductible health plan must have a high deductible before kicking in to cover medical expenses. In 2020, the minimum deductible required is $1,400 for an individual or $2,800 for a family.

Beyond a minimum deductible, HDHPs must also limit the maximum out-of-pocket liability. In 2020, that maximum annual liability is limited to $6,900 for individuals and $13,800 for families.

The HSA was created under Title XII of the 2003 Medicare Prescription Drug, Improvement and Modernization Act. This act 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. The tax benefits encourage you to set aside enough money to cover your medical bills before your health insurance kicks in at your deductible.

And the tax benefits are impressive.


Tax Advantages

Under federal tax law, you cannot itemize and deduct medical expenses unless your medical expenses exceed 7.5% of your gross income, not including health insurance premiums. This requirement prevents most Americans from deducting any medical expenses from their gross incomes, meaning most medical costs are paid with after-tax dollars.

Health savings accounts offer the best tax advantages of any tax-sheltered account. Specifically, they come with triple tax protections: Contributions are tax-free, the money grows tax-free, and withdrawals are tax-free.

Tax-Free Contributions

Like IRAs, contributions to your HSA are deductible from your taxable income.

You can deduct contributions up to $3,550 for individuals or $7,100 for families with high-deductible health plans. Taxpayers over 55 can contribute an extra $1,000 in catch-up contributions, much like with IRAs.

That means you get a tax break today, creating an immediate return on your contributions.

Tax-Free Growth & Withdrawals

With retirement accounts, investors have to choose between a tax break now (as with traditional IRAs) or tax break later when they withdraw funds (as with Roth IRAs).

With HSAs, you get both, no tradeoff required. You take the deduction this year, the money grows and compounds tax-free, and you can withdraw it tax-free at any time to pay for medical expenses. This means you don’t have to wait until you’re 59½ to access the funds, like with an IRA.

The caveat? You can only withdraw money from your HSA to cover health-related expenses. Fortunately, that’s a huge umbrella. It includes not just doctor’s appointments and medications but also eyeglasses, contact lenses, dental care, fertility costs, birth control, bandages, hospice care, psychotherapy, and any other conceivably health-related expenses. IRS Publication 502 contains the complete list of eligible medical and dental expenses.

The IRS places no limit on the fund balance, which can accumulate over your lifetime.

Tax-Deferred Withdrawals: Nonmedical Expenses

Funds deposited into an HSA can be withdrawn at any time. However, the IRS taxes withdrawals made before age 65 and not used for qualified medical expenses at ordinary income tax rates plus a 10% penalty.

After age 65, withdrawals for nonmedical expenses are taxed at ordinary tax rates without the penalty.

Again, HSAs follow rules similar to those of IRAs. If you pull money out in retirement for nonmedical expenses, you pay no more in taxes than you would with a traditional IRA.


Other Perks of HSAs

The advantages of HSAs don’t end at the tax benefits. As you consider combining a high-deductible health plan with an HSA, consider the following perks as well.

Portability

Unlike many employment benefits, you own an HSA. It remains intact whether you remain with the same employer, replace account administrators, alter your investment strategy or choices, or change your insurer (provided your new policy continues to qualify as a high-deductible health insurance policy).

If the account still contains funds upon your death, ownership transfers to your named beneficiary or is distributed as part of your estate. If you’re married, the HSA funds simply flow to your surviving spouse’s HSA account. If there is no surviving spouse, the untaxed growth is taxed at the heir’s normal income tax rate.

Flexibility

Like in an IRA account, you get to invest in whatever you want.

Eligible investments in an HSA include stocks, ETFs, REITs, bonds, mutual funds, savings accounts, and other investments depending upon the options allowed by your HSA administrator of choice. In addition, each HSA administrator typically provides a range of account services, including special checking accounts, debit cards, and electronic bill payment.

With that kind of flexibility, it’s no wonder some savvy investors use their HSA for more than just an extra checking account for health expenses.

Additional Uses: Retirement Investing & Emergency Funds

Spoiler alert: You’re going to have a lot of health-related expenses in retirement. One report by Fidelity found that the average couple spends $285,000 on health care after the age of 65.

High medical expenses will be a reality when you retire. So why not invest money for them now, tax-free?

The tax benefits of an HSA are better than those of an IRA or 401(k). You lower your tax bill this year with contributions, and you avoid paying taxes later on the withdrawals. Some investors contribute first to their HSA, then contribute to their IRA only once they’ve reached the HSA annual contribution limit.

Another creative approach to using your HSA is as an additional layer of your emergency fund. Say you have $2,000 in your regular savings account with CIT Bank, $10,000 in your HSA, and a deductible of $3,000 for your health insurance. You contribute part of every paycheck to your HSA as a tax-sheltered, growth-oriented account. Then, you choose investments like you would in an IRA.

Imagine that in March, you face a $1,000 medical bill. You pay it out of your normal savings account, leaving your HSA untouched and invested to grow tax-free, hoping you don’t get hit with any other medical expenses that year. But in October, you face another $2,000 medical bill.

You can, of course, tap into your HSA for that October bill. You can also retroactively withdraw money to pay for your March bill too, if you like. Because you can withdraw funds at any time throughout the calendar year for health expense reimbursement, it gives you the flexibility to try to cover your health expenses with cash and later decide if you want to tap into your HSA for them.


Who Can Establish an HSA?

Anyone with a high-deductible health plan can open an HSA, regardless of whether you, your spouse, or your employer pays the premium. That means that the self-employed and other people without employer health coverage can also buy an HDHP and open an HSA to go with it.

Beware that while most health insurers offer high-deductible policies, not all such policies qualify to pair with HSAs. 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 an HSA

Higher earners pay a higher percentage of their income to taxes based on our graduated income tax bracket system. The higher your taxable income, the greater your potential tax savings by establishing an HSA.

Even so, many lower- and middle-income earners would benefit from replacing an expensive low-deductible health insurance policy with a high-deductible policy. All else being equal, an HDHP combined with an HSA makes financial sense if you fit either of the following two criteria:

  1. The savings on your annual premium equals or exceeds the increase in deductible. For example, you come out ahead if you save $3,000 on the annual premium by increasing your deductible by $3,000 or less. Remember, the premium is a guaranteed expense, while the deductible represents only a possible expense.
  2. You pay substantial out-of-pocket medical expenses, but you can’t deduct them because they total less than 7.5% of your adjusted gross income. Using an HSA allows you to pay your medical expenses with pretax 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. After age 65, you can withdraw the accumulated funds in the HSA for any purpose without penalty. Many financial advisers have developed exotic — although effective — strategies to maximize retirement income from combined Social Security payments and private accounts such as IRAs, HSAs, and 401(k)s.

Before electing a withdrawal strategy, speak with a competent financial advisor to make sure it fits your personal long-term financial goals.

Pro tip: If you’re thinking about hiring a financial advisor, start your search with SmartAsset. They have a tool where you can answer a few questions and they’ll match you with a qualified financial advisor in your area.


How to Set Up an HSA

Virtually all of the major health insurers offer high-deductible health plans among their group and individual policies. To complement them, many insurers also offer in-house HSA administrative services.

That said, you can usually find the most flexibility among brokerage accounts. Check to see if your broker offers HSA administration, or if you don’t already work with one, see our list of the best HSA administrators.

Once you’ve chosen an HSA administrator, you can follow these steps to open the account online:

  1. Get Insurance Quotes. Collect quotes from the major health insurers in your state. Don’t be afraid to shop around, and choose the health insurance policy that best fits your needs. Many insurers have an affiliate or subsidiary company or will recommend a company that can establish and administer an HSA at the time you purchase your health insurance.
  2. Select an HSA Administrator. If you prefer to use a noninsurance administrator, there are a number of major banks and financial entities that offer HSA accounts in the hopes of helping you with the investments within them. You can also use a company like Lively.
  3. 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 explains the process whereby you can change investments. In most cases, you receive a debit card tied to the HSA to facilitate record keeping, along with monthly or quarterly statements regarding the fund’s investments and balances.

Administrative Fees

As with most financial and insurance products, brace yourself for fees.

You may 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 what you would pay to open and maintain an IRA or 401(k) retirement account. Many of the best HSA administrators charge fees under $3 per month, and some waive those fees if you maintain a minimum balance.

HSAs are highly regulated instruments offered by the largest, most reputable insurance firms and banks in the United States. As such, you can expect full transparency with all fees that apply to your account.


Final Word

As people age, the proportion of their income devoted to maintaining health increases. Rare is the person who lives a long life with no significant medical expenses.

Establishing an HSA allows you to save and invest for inevitable medical costs while doubling as a retirement account for other purposes when you’re older. HSAs combine flexibility with unique tax benefits not available in any other account type.

If they have a downside, it’s that many people are reluctant to seek preventative care when they have to pay for it out of pocket. Resist the urge to save a few dollars today at the expense of your health tomorrow. Even from a purely financial perspective, preventative care saves you thousands of dollars in lifetime health expenses by catching problems early before they require more expensive and invasive treatments.

Are you considering making the switch to a high-deductible health plan and HSA? Why or why not?

G. Brian Davis
G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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