Q: What retirement investment isn’t taxed on the front end or the back end, is eligible for a tax deduction, and doesn’t penalize you for early withdrawals?
A: A health savings account.
You’ve probably never heard of them, but HSAs have been around for a decade. Fewer than 10 percent of Americans have one, according to a recent InsuranceQuotes.com survey of about 1,000 adults. But half agree they’re a good way to cut the tax bill, and nearly a third agree it would make paying for health care easier. And the IRS just raised the amount you’re allowed to put in next year.
They’re becoming popular fast, mainly because employers see them as a way to avoid an Obamacare tax coming in 2018, according to Reuters. Data released in February by Devenir Research show 10.7 million people now have one, up 30 percent compared to a year ago.
There are a few catches: Not everybody qualifies for one, and you can be taxed if you break the rules. But if you have a qualifying health plan, you can stash up to $3,300 a year ($3,350 in 2015) for medical expenses if the plan is just for you, or $6,550 a year ($6,650 in 2015) for a family plan. And if you’re over 55, you can add an extra $1,000 per year. Intrigued? Here are the details…
Can you get an HSA?
To qualify for an HSA, you need a certain kind of health insurance known as a high-deductible health plan. (Or an HDHP, because in the medical world, everything is an acronym.) You can’t get one if you’re enrolled in Medicare or can be claimed as a dependent on someone else’s tax return.
Deductibles are how much you pay out of pocket before your insurance kicks in. So having a high deductible makes your premium cheaper, but means you pay more directly for your care. Whether the costs balance out compared to a traditional health plan depends on your overall health.
To be dubbed an HDHP, there are two requirements. First, an individual plan requires a deductible of at least $1,250, and a family plan double that. Second, there has to be an annual cap for out-of-pocket expenses: $6,350 for an individual and $12,700 for a family.
The federal government has separate definitions for HDHP and catastrophic plans — you generally have to be under 30 to get catastrophic coverage. But the two terms often overlap because these kinds of plan make the most sense for people who are young and healthy, anyway.
How an HSA works
So, you can get an HSA. But how do you use it, and where do you get these things?
Many employers offer them alongside health insurance, but you don’t need to get one through your employer or from the same health provider, according to the IRS. You don’t even have to go through a traditional insurance company at all, since more than 2,200 banks and credit unions offer them, according to Devenir Research.
You can treat an HSA like a savings account, where it’s completely safe, FDIC-insured, and gathers a tiny bit of interest. Banks like State Farm Bank often give you a debit card for the account. With some, like Chase, you can even get old-fashioned checks for HSA expenses.
You can also treat an HSA like an investment, where you risk losing money but can also make a lot more, and it’s tax-free if you follow the rules. Many companies that offer HSAs put your contributions into mutual funds. Wells Fargo lets you start with the savings account and then graduate into an investment account.
Here are some other things to keep in mind when you set up an HSA…
- There’s no such thing as a joint HSA, even if your HDHP is a family plan. Each eligible individual needs their own, and they all count toward the annual contribution limit.
- You don’t lose any HSA money if you leave the HDHP plan. You can still keep and use it — you just can’t make additional contributions unless you’re in one.
- You don’t have to spend HSA money right away. If you can afford to pay out of pocket and keep good records of qualified expenses (more on that later), you can get reimbursed for them at any time — while your investment is still earning tax-free money.
- You can make contributions for a given year until tax day of the following year — so you could still make deposits for 2013 until April 15, 2014.
- Even if you don’t owe tax on them, you’re supposed to report withdrawals (or “distributions”) to Uncle Sam.
What you can spend an HSA on
InsuranceQuotes.com’s survey showed most people have no clue how an HSA works or what you can spend the money on — which is probably why most people don’t have one, and why the site created a six-question quiz to help educate folks. (Read this first and you’ll ace it.)
You can spend HSA money on whatever you want, but that’s a bad idea. If the expenses aren’t qualified, you suddenly owe income taxes on that money, and you get hit with a 20 percent penalty if you’re younger than 65. So what qualifies?
Here’s the big thing that usually doesn’t: Your health insurance premium. More than half of the people surveyed got this wrong. But there are a few exceptions: HSA money can be used to pay premiums for continuing coverage like COBRA, coverage while you’re collecting unemployment, Medicare or other coverage if you’re over 65, and long-term care insurance.
The really inspired part of HSA rules: You can use an HSA to pay for things in your deductible — yeah, the very out-of-pocket threshold that has to be high enough to qualify for an HSA.
You also can’t spend it on any over-the-counter meds, other than insulin, unless you get a prescription for them. And you can’t spend it on a gym membership, either, although 22 percent think you can. Here’s some more stuff you can spend it on, according to the IRS…
- Alcoholism treatment
- Birth control
- Braille books that cost more than regular printed editions
- Breast pumps
- Contact lenses
- Dental treatment (besides cosmetic stuff like teeth whitening)
- Hearing aids and batteries
- LASIK eye surgery
- Legal abortions
- Nursing homes
- Surgery (besides cosmetic surgery)
- Tuition for children with learning disabilities
HSA vs. FSA
HSAs are often confused with flexible spending accounts because both can be used to pay for medical expenses, and like an FSA or 401(k), employers can contribute to your HSA. (That money still counts toward your contribution limit.)
But there are some key differences. The big things are that HSAs can be invested, and they aren’t use-it-or-lose-it. FSAs require careful planning and guesswork and stress to avoid losing money at the end of the year. FSA contribution limits are also lower, at $2,500 a year.
Because you don’t risk losing your money in an HSA, you might worry about putting in more than you need for medical expenses in retirement. But there’s really no way for retirees to screw it up.
“Even if they end up drawing down the money for non-medical purposes in retirement, the end result is no worse than a traditional tax-deferred account,” Reuters says. It just gets taxed on the back end like an IRA.
Should you get an HSA?
If you’re already in an HDHP, the answer is obviously yes. Otherwise, it’s up to you. Some people see them as a way to cover medical expenses, some as a long-term investment, and some as a really dumb idea. But the best people to ask are the ones who already have HSAs.
The U.S. Government Accountability Office surveyed people who had one in 2006, when they were relatively new. Says the GAO:
HSA-eligible plan enrollees who participated in GAO’s focus groups generally reported positive experiences, but most would not recommend the plans to all consumers. Few participants reported researching cost before obtaining health care services, although many researched the cost of prescription drugs. Most participants were satisfied with their HSA-eligible plans and would recommend them to healthy consumers, but not to those who use maintenance medication, have a chronic condition, have children, or may not have the funds to meet the high deductible.
Art by Brendon Lies