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Health Savings Accounts have become the go-to savings vehicle for millions of Americans. According to Devenir, a major provider of HSA consulting services, over 30 million Americans own Health Savings Accounts, with an estimated value of more than $80 billion.
Depending on how you intend to use your HSA, there are two major strategies that most people follow and a third one that you may want to strongly consider.
What is a Health Savings Account?
Health Savings Accounts (HSAs) are tax-advantaged savings accounts designed to help individuals with high-deductible health plans (HDHPs) save money for medical expenses. Like most tax-advantaged accounts, there are some rules:
Eligibility: To open an HSA, you must be covered by a high-deductible health plan (HDHP). For 2023, the minimum deductible for an HDHP is $1,400 for an individual and $2,800 for a family. You must not have any other disqualifying health coverage.
Contribution Limits: For 2023, individuals can contribute up to $3,750 to their HSA; families can contribute up to $7,500. If you are 55 or older, you can make an additional "catch-up" contribution of $1,000 per year. Contributions to HSAs are tax-deductible, and the money grows tax-free. It’s a triple tax win.
Qualified Medical Expenses: HSA funds can be used to pay for qualified medical expenses, including deductibles, copays, and prescriptions. Some medical expenses, such as cosmetic procedures, are not considered qualified medical expenses. If you use HSA funds for non-qualified expenses, you must pay income tax on the amount withdrawn plus a 20% penalty.
Withdrawals: Withdrawals may be made from your HSA at any time to pay for qualified medical expenses. If you withdraw money for non-qualified expenses before age 65, you will have to pay income tax on the amount withdrawn plus a 20% penalty. After age 65, you can withdraw money for non-medical expenses without penalty, but you will have to pay income tax on the amount withdrawn.
Portability: Unlike flexible spending accounts (FSAs), HSAs are portable, meaning you can take them with you if you change employers or retire.
Now that you are caught up on the basics here are the three strategies for managing your Health Savings Account:
Strategy 1 – Save and Spend. When I first set up my Health Savings Account, I would fully fund it every year up to the maximum amount allowed – generally, the amount of the deductible. Then I would spend down the balance over the course of the year to pay my out-of-pocket medical expenses like deductibles, copays, prescriptions, etc. Any money left over would carry into the next year. Gradually my balance would build up as long as my family and I stayed healthy.
My logic was that I was getting a tax-break on the contribution. And since withdrawals were not taxable, I was essentially paying for my medical bills with pre-tax money.
The “Save-Spend” strategy also misses out on another important tax benefit of Health Savings Accounts: Tax free growth of your account balance.
It’s not a bad strategy, but you won’t accumulate much in your HSA if you keep making distributions.
Strategy 2 – Save and Defer. Save-Defer means you contribute the maximum amount to your Health Savings Account every year. Unlike the Save-Spend strategy, Save-Defer means that you don’t touch this account, except for the really big bills. Smaller medical expenses like a standard teeth cleaning at the dentist can be funded out of pocket. When your dentist tells you that you need a $1,500 crown, you pay for it out of the HSA.
This way, you still get the tax deduction for your annual contribution. The money is there for the bigger bills that come up occasionally, and you are more likely to accumulate a larger, tax-deferred balance over time.
In the future, if you have a large balance in your HSA, you may use it to pay for Medicare premiums, long-term care expenses or other qualified health care expenses on a tax-free basis.
Save-Defer is not a bad way to go until you realize that in many cases your health insurance may not cover everything.
If you or a family member suffers a medical emergency or a more serious medical issue, it’s possible that your health insurance might not cover everything. Even if it does cover all your medical bills, your family maximum out of pocket can be as much as $20,000 or more – per year! People with a chronic condition could end up paying their family maximum out of pocket every year for many years.
Expenses like these can wipe a family out or at least set it back several years.
Strategy 3 – Save-Defer-Never Spend. Using this strategy your Health Savings Account becomes a type of tax-free, major medical cash reserve that is only tapped in the most extreme financial medical emergencies.
Save-Defer-Never Spend takes advantage of all three of the Health Savings Account tax benefits: tax deduction on your contribution, tax deferred growth, and tax-free qualified distributions. More importantly, this strategy provides a large source of tax free money to pay major medical expenses in the future.
Of course, this strategy only works if you can afford to pay your routine medical expenses (deductibles, co-payments, max out-of-pocket) from cash flow or other savings. Clearly, not everyone can do that. But to the extent that you can afford to pay for your dental work or eyeglasses or other routine HSA qualified expenses out of pocket, you might want to do so.
It won’t happen to me? Think again. According to the Kaiser Foundation, 9% of Americans have some level of medical debt. 1% owe more than $10,000. Of those who reported medical debt, 11% had debt in excess of $50,000 (affordablehealthinsurance.com).
“But I have insurance”. So do half of all people with medical debt. (affordablehealthinsurance.com)
Hopefully, you will never need a large balance in your Health Savings Account, but if you do, it can make a big difference in your long-term financial security.
The Employee Benefits Research Institute reports that the average HSA balance in 2020 was $3,200. If you don’t have enough money in your Health Savings Account to cover 2-3 years of max-out-of-pocket expenses, Save-Defer-Never Spend might be something to consider.
To discuss any of the topics in this blog or to learn more about how we can help you Cross The Bridge To A Confident Retirement, please contact me through my web site mikebranch.net, call me directly at 651-379-3935 or email me at mpbranch@focusfinancial.com.