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Do I Need an HSA?

Do you have an HSA? And if you don't, should you have one? Let's take a look at the benefits of establishing an HSA for yourself or your family.

First of all, HSA stands for Health Savings Account. As the name suggests, it is a way to save and pay for health related expenses. What the name doesn't imply though, is that it is also a way to reduce your taxable income. Who wouldn't want those two things?

Qualifying Expenses

There are a wide range of medical, dental, and mental health services that are considered to be eligible expenses for payment from an HSA. For more information on these qualifying expenses, check out IRS Publication 502, Medical and Dental Expenses. Paying for these expenses couldn't be simpler. Most HSAs provide you with a debit card. This makes paying for things like office visits and prescriptions extremely convenient. If you receive a bill in the mail for your medical services that are not covered under your health insurance plan, you can also pay this bill with your debit card by calling the billing office and providing them with your debit card information.

As part of the CARES Act that was signed into law at the end of March, you are now allowed to use your HSA to pay for  over-the-counter drugs and medicine, such as allergy medications and pain relievers, without a doctor’s prescription. This reverses a provision of the Affordable Care Act that required a prescription for these types of purchases.

Insurance premiums are usually not considered a qualifying medical expense when it comes to HSAs. However, premiums for Medicare or other healthcare coverage - including long-term care insurance -  are qualifying medical expenses if you are over the age of 65. Also, if you are unemployed and receiving unemployment compensation, your health insurance premiums are also considered to be  qualified medical expenses. This is particularly important during the current COVID-19 pandemic.

You need to be careful. If you take a distribution from your HSA for any reason other than paying for qualified medical expenses, the amount that is withdrawn will be subject to both income tax and an additional 20% tax penalty.

Establishing an HSA

Before you can set-up an HSA, you need to qualify to do so. In order to qualify, you must be enrolled in a high-deductible health insurance plan (HDHP). The U.S. Government has established that for 2020, an HDHP for an individual is a health insurance plan that has a minimum annual deductible amount of $1,400 and a maximum annual out-of-pocket expense of $6,900. If you have a family insurance plan, then the minimum annual deductible must be $2,800 with a maximum annual out-of-pocket expense of $13,800. Just to clarify; out-of-pocket expenses are things such as deductibles, co-pays, and other fees. They do not include health insurance premiums.

So how does this all work and what about reducing your taxable income? Every year you can contribute to your HSA any amount up to the government-mandated maximum. Just as IRAs and 401Ks have maximum contribution amounts, so do HSAs. For 2020, the maximum contribution to an HSA for an individual is $3,550. This represents a $50 increase over the 2019 amount. For a family, the maximum contribution is $7,100, which is up $100 from 2019. Here's an added bonus. If you are 55 years of age or older, you can contribute an additional $1,000 to your individual or family account. On top of this, these contributions are 100% tax-deductible!

Another attractive benefit of an HSA is the fact that unlike a Flexible Spending Account (FSA), your HSA balance rolls over from year to year. You do not have to spend it or lose it each year as you do with an FSA. Once you turn 65 and enroll in Medicare, you are no longer eligible to contribute to your HSA, but you can still use the funds in your HSA to pay for out-of-pocket medical expenses. If you decide to use HSA funds on non-qualified medical expenses, you will have to pay income tax on the amount that you withdraw. There is no 20% penalty if you are over the age of 65.

HSA Tax Advantages 

In total, HSAs have three tax advantages.

  1. Your HSA contributions are tax-deductible.
  2. Your money within your HSA grows tax-free.
  3. Withdrawals that are used to pay qualified medical expenses are also free from income tax.

Sounds pretty good. But there are still more benefits to mention. First, money within your HSA can also be invested in mutual funds for the potential for higher growth than if the funds were left in cash. Second, unlike IRAs and other retirement accounts, there are no Required Minimum Distributions (RMDs) once you reach the age of 72. And finally, if you make your HSA contributions through payroll deductions with your employer, these contributions will not be subject to Social Security and Medicare (FICA) taxes. So in addition to escaping Federal and state income taxes, you will also avoid the 7.65% FICA tax hit. While your 401K contributions escape Federal and state income taxes, they do not escape the FICA tax.

While not the optimal solution for everyone, an HSA is a very attractive way to reduce your health insurance costs while at the same time saving for future medical expenses in a triple tax-advantaged way.