A Health Savings Account (HSA) is a tax-advantaged account created for individuals who are covered under high-deductible health plans (HDHPs) to save for qualified medical expenses that are over and above an HDHPs coverage limits and/or exclusions. Contributions are made into the account by the individual or the individual’s employer and are limited to a maximum amount each year. The contributions are invested over time and can be used to pay for qualified medical expenses, such as medical, dental and vision care, as well as prescription drugs. With the CARES act enacted into law in response to the Coronavirus pandemic, HSA funds can now be used for over-the-counter medications without a prescription, as well as certain other health-related products. If in doubt about whether something is an eligible expense, check with your local pharmacist or HSA plan administrator.
How an HSA Works
There are two key requirements that determine whether or not a health plan qualifies as an HDHP and, therefore, HSA-eligibility. First, for the tax year 2020, the plan must have a minimum deductible of $1,400 for an individual or $2,800 for a family. For tax year 2021 those amounts stay at $1,400 and $2,800 respectively. Essentially, the deductible means that the plan pays nothing until you reach these amounts in out-of-pocket expenses.
The second requirement is that HDHPs are required to have an annual out-of- pocket maximum. For tax year 2020 those amounts are $6,900 for individual coverage and $13,500 for family coverage. Similarly, those amounts increase to $7,000 and $14,000 respectively in 2021. These maximums basically place a cap on your out-of-pocket expenses, which can be beneficial depending on your individual circumstances.
In order to open and contribute to an HSA for themselves or their family, an individual needs to be enrolled in an HDHP. Please note, HDHPs are insurance plans that typically have higher annual deductibles, but lower premiums than other health plans, which may or may not be beneficial financially, again, depending on your particular set of circumstances.
When an individual has paid the portion of a claim they are responsible for, the insurance company will cover a percentage of the remaining portion, typically 80%-90%, as specified in the contract.
For example, under the HDHP, an individual with an annual deductible of $1,500 who makes a medical claim for $3,500, will be responsible for 100% of the first $1,500 to cover the annual deductible. Of the remaining $2,000 the insured will be responsible for an additional 10%-20%, again, as specified in the contract, and the insurer covers the rest.
Note, once the annual deductible is met in a given plan year, any additional medical expenses will typically be covered at 80%-90% as described above. To supplement the funds that an insured has to pay out-of-pocket, the money accumulated in a Health Savings Account (HSA) can be used.
Qualifying for an HSA
An individual who has an HDHP may qualify for a Health Savings Account. The HSA is usually paired with a qualified HDHP and offered by a health insurance provider. An HSA can also be opened at a number of financial institutions. To qualify for an HSA, the taxpayer must be eligible, as per standards set out by the Internal Revenue Service (IRS). An eligible individual is one who has a qualified HDHP, has no other health coverage, is not enrolled in Medicare, and is not claimed as a dependent on someone else’s tax return.
Any eligible individual can contribute to an HSA in cash only. An HSA owned by an employee can be funded by the employee and the employer. Any other person, such as a family member, can also contribute to the HSA of an eligible individual. Individuals who are self-employed or unemployed may also contribute to an HSA, provided they meet the qualifications of owning a Health Savings Account in the first place.
For 2020, the contribution limit to an HSA is $3,550 for self-coverage.In 2021 it will rise $50 to $3,600. Individuals with families can contribute up to $7,100, rising to $7,200 in 2021. Individuals who are 55 years or older by the end of the tax year can contribute an additional $1,000 to their HSAs. Contributions made by an employer to an HSA are included in the limit. For example, an individual who opts for the maximum 2019 contribution limit of $3,500 can contribute only $2,000 if their employer contributes $1,500.
Tax Advantages of an HSA
HSAs have a number of advantages (as well as drawbacks). The HSA is most advantageous to account owners because funds are contributed to the account using pre-tax income. The portion of pre-tax income that is used to fund an HSA lowers a taxpayer’s total taxable income, translating into a lower tax liability for the individual.
In addition, contributions made to an HSA are 100% tax-deductible, and any interest earned in the account is tax-free. However, excess contributions made to an HSA incur a 6% tax and are not tax-deductible. Aside from a few administrative changes, the Tax Cuts and Jobs Act of 2017 did not directly affect HSAs.
The most obvious key drawback: You need to be a good candidate for an HDHP. Healthy people with limited medical expenses who will benefit from paying lower premiums and affluent families who will benefit from the tax advantages and can afford the risk of higher deductibles are two groups who fit these parameters well.
Withdrawals Permitted Under an HSA
As long as withdrawals from a Health Savings Account are used to pay for qualified medical expenses that are not covered under the HDHP, the amount withdrawn will not be taxed.
- Qualified medical expenses include deductibles, dental services, vision care, prescription drugs, co-pays, psychiatric treatments, and other qualified medical expenses not covered by a health insurance plan, which have been expanded by the CARES act, as mentioned earlier.
- Insurance premiums usually don’t count towards qualified medical expenses unless the premiums are for Medicare or other healthcare coverage if 65 years or older, for healthcare insurance while unemployed and receiving unemployment compensation and for long-term care insurance.
If any distributions are made from an HSA for reasons other than paying for medical expenses, the amount that is withdrawn will be subject to both income tax and an additional 20% tax penalty. Individuals who are 65 years old or older will no longer be able to contribute to an HSA but can withdraw any funds accumulated in the account for any expense without incurring the 20% penalty. However, income tax will still apply to any non-medical usage.
HSA Contribution Rules
Contributions made to an HSA do not have to be used or withdrawn during the tax year. Any unused contributions can be rolled over to the following year. Also, an HSA is portable, meaning that if an employee changes jobs, they can still keep their HSA. In addition, an HSA plan can be transferred to a surviving spouse tax-free upon the death of the account holder. On the downside, HSAs come with specific withdrawal rules and a recordkeeping burden that may be difficult to maintain.
All in all, HSAs are one of the best, tax-advantaged savings and investment tools available under current IRS regulations. They are often referred to as “Triple Tax-Advantaged”; your contributions are tax deductible, the money grows tax free and withdrawals are not taxed, provided they are used for qualified medical expenses. In addition, money in an HSA can be invested in stock and other securities, potentially allowing for higher returns over time. As a person ages medical expenses tend to increase, particularly when reaching retirement age and beyond. Starting an HSA at an early age, if you qualify, and allowing it to accumulate over a long period of time, can contribute greatly to securing your financial future.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing. The information provided is not intended to be a substitute for specific individualized tax planning or legal advice. We suggest that you consult with a qualified tax or legal advisor.