Most income tax benefits have symmetry. For example, if you defer income by contributing to a 401(k) plan, you are not taxed on the income that you contribute. Down the road when you distribute those funds out of your 401(k) plan, those distributions are taxable. Similarly, if your contributions are not tax deductible now (like a Roth IRA contribution), your distributions in retirement can be tax-free.
Health Savings Accounts (HSAs) defy that tax symmetry and provide the best of both worlds: a tax deduction for contributions now and tax-free distributions later. Contributions into HSAs are tax deductible, and then earnings and distributions are tax-free when used for certain qualified health expenses.
How do you know if you are eligible for a Health Savings Account?
Your health insurance must be a qualifying “high-deductible health plan” (HDHP) and have an expenses limit, or maximum, on out-of-pocket costs. For individual coverage, that means health insurance with at least a $1,400 annual deductible and $7,000 of maximum out-of-pocket expenses. For family coverage it must be at least a $2,800 annual deductible and $14,000 maximum on out-of-pocket expenses.
If you are enrolled in Medicare, HSA contributions are no longer allowed. You can still use any existing HSA funds, but can no longer contribute to the account.
If eligible, how do you set up an account?
You don’t need anyone’s permission to establish a Health Savings Account (although your employer may establish and fund an HSA for you). You are the owner of the account and it is not part of your health insurance plan. You can open an HSA through some banks and other financial institutions. The funds don’t have to be spent annually like a Flexible Spending Account, where you “use or lose it.” The balance rolls over from year to year and is yours to spend at your discretion. A Health Savings Account is similar to an IRA and can be invested at a “qualified custodian”. This is typically done through a bank, insurance company, or brokerage firm. Your HSA can be thought of as an extra retirement account or a special purpose medical expense emergency fund.
How much can you fund annually?
If you have individual coverage, you can contribute $3,600 for 2021. For family-coverage, the contribution limit is $7,200. If you are over 55, you can contribute an extra $1,000. As with an IRA, you have until April 15th of the following year to make your annual deductible contributions.
What happens when you distribute funds from the HSA?
Distributions from an HSA that are for “qualified medical expenses” are not taxed. Qualified medical expenses are expenses not covered by insurance that would be deductible as medical expenses on your tax return. Eyeglasses, dental expenses, co-pays, and many more expenses qualify. You can even use your HSA to pay long term care premiums and health insurance if you are on COBRA or are receiving unemployment. Review IRS Publication 969 for more information about eligible expenses.
If you take Health Savings Account distributions for non-medical expenses before you are age 65, you will pay tax on the distribution and an additional 20% penalty tax. If you take an HSA distribution for non-medical expenses after you are 65, you will pay tax on the distribution like you would from a traditional IRA, but will not be subject to the penalty tax. This means you could be using your HSA as another retirement savings tool (similar to the IRA).
Not everyone has medical expenses, but the HSA can still be a tool for retirement planning. If you have high levels of income, this may be a great vehicle for you to make some tax-deferred retirement contributions that you may normally be phased out of. It’s just one other retirement savings bucket that may be worth considering whether you have current medical expenses or not.
Unlike an IRA or 401(k), HSAs have no required minimum distributions at age 72, so taxes can be deferred longer. After death, your surviving spouse can take over the HSA and keep using it. A non-spouse beneficiary who inherits the account, like a child, will pay tax on the account value at death.
HSAs can get complicated quickly. Call us, we’re here to help!
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