A Health Savings Account ("HSA") is a tax-advantaged account for individuals enrolled in a high-deductible health plan ("HDHP") allowing them to contribute tax free money to be used for medical expenses. As with any tax-advantaged account, the IRS does impose some limitations. We've included the 2016 limits below but encourage savers to stay on top of these as they are updated annually. There are also $1,000 additional catch-up contributions for taxpayers over the age 55 too.
|Maximum Annual HSA Contribution
|Minimum Annual Deductible for HDHP
|Maximum annual out-of-pocket spending limit for HDHP
Who should use an HSA?
If you have a HDHP or anticipate high-out-pocket medical, dental, or orthodontic expenses in the coming year, it may make sense to contribute to an HSA, as the money going in and coming out (assuming those outflows are qualified healthcare expenses) is pre-tax. There aren’t many tax shelters like the HSA, where you put in pre-tax dollars and withdraw it tax-free. It’s really a valuable way to stretch your paycheck further and have Uncle Sam pony up for a portion of you medical expenses.
Assuming you’re in the 30% effective tax bracket this year, that’s like having a coupon for 30% off healthcare expenses. One way to decide how much to set aside is to look at your historical spending for out-of-pocket medical expenses. Or if someone in the family needs a procedure in the near future, you may want to contribute in advance toward your out-of-pocket share to take advantage of the 30% savings. The best part is that HSA funds roll over from year to year even if you leave your employer, so there is no “use it or lose it” risk.
Investing the HSA assets
A family can put up to $6,750 pre-tax, into an HSA per year. And here’s something interesting: after it has $2,000 in it, it can be treated as an investment and put it into different mutual funds. Any earnings on your investments grow tax-free, provided you use the proceeds on legitimate medical expenses in the future. That translates to a triple-tax-benefit: tax deduction on contributions, tax-free distributions, and tax-free compounding Growth!
On the other hand you can begin withdrawing for non-medical expenses after age 65, and the amounts will be taxed at ordinary rates similar to a traditional IRA or 401 (k). However, if you withdraw for non-medical expenses before age 65, not only will you be taxed, but there’s also a 20% federal penalty. There is also a small risk when your cross over into investment territory with your HSA too. Once invested, you do lose FDIC insurance on the funds however, this is true of all investments and is similar to investments held in IRAs and other tax-advantaged accounts. We also warn that you make sure to keep enough of the account in cash to fund actual healthcare expenses for the year. Otherwise you may run into issues trying to liquidate those funds.
Getting started with an HSA
To get started open an HSA account at your bank and begin contributing tax-deductible dollars up to the annual maximums detailed above. You will need to report contributions and distributions for medical expenses on form 8889 with your federal tax return as well. Best practice is to file all medical receipts so you can verify for your tax preparer that all HSA funds were spent toward qualified expenses. Though HSA's come with a bit of an administrative burden, they are one of the best tax shelters out there for folks with high-deductible plans!
- Greg Maravilla, CPA, CFO Advisor at PracticeCFO