Looking for a savings plan that has more immediate tax and long-term advantages than either a regular or Roth IRA? That would be a Health Savings Account.
A Health Savings Account (HSA), as the title implies, is a tax-advantaged tool to save for medical expenses that high-deductible health plans do not cover. The advantage of high-deductible insurance plans are lower premiums up front. High deductible insurance plans pay nothing until the insured reaches the deductible limit.
An HSA fills the gap in the short term by accumulating tax-free cash for health expenses. The HSA can also serve as a long-term savings and investment scheme that can grow and accumulate funds to pay for higher medical expenses during your retirement years.
Contributions to HSAs, like regular IRAs are through pre-tax dollars. When you contribute to an HSA, you reduce your taxable income. However, unlike regular IRA distributions, reimbursements for medical expenses distributed from the HSA are not taxed. Likewise, any interest accruing in the HSA investment are tax free. So, the bottom line is that you never pay any taxes on the HSA account.
Caution: You can withdraw funds from an HSA, but you must be careful on where you spend the money. Using HSA funds for any reason other than paying for qualified medical expenses can subject you to taxation as ordinary income as well as a 20% penalty.
The Basics of the HSA
You can sign up for a Health Savings Account if you:
- have a qualified high-deductible health plan—a health-insurance plan with high minimum out-of-pocket charges.
- have no other health coverage plans
- are not enrolled in Medicare
- are not claimed as a dependent on another person’s tax return
Qualified high-deductible health plan minimum deductibles for 2021 are $1,400 for self-only insurance policies and $2,800 for family insurance plans. The insurance plan must also cap out-of-pocket expenses at $7,000 for single coverage and $14,000 for families.
You can open an HSA at qualified financial institutions through cash contributions. HSA custodians include banks and financial services specializing in managing HSAs. Shop around and compare annual maintenance fees. Some require a minimum cash balance of $2,000 and have a variety of estimated annual account maintenance costs.
Don’t confuse HSA with FSA
A Health Savings Account (HSA) should not be confused with Health Flexible Spending Account (FSA). An FSA is an arrangement with your employer that, like an HSA, allows you to be reimbursed for out-of-pocket medical expenses with tax-free dollars, but does not accrue lifetime savings.
Only people who are employed can sign up for FSAs. An FSA is strictly a job-based plan designed to cover high insurance copayments. The tax advantages cover only what you contribute to the plan through the pay that your employer deducts from your paycheck. The maximum contribution for the 2021 tax year for an FSA account is $2,750.
Do Your Homework
See IRS Publication 969 for a detailed explanation of how both plans work, along with examples, exceptions, and a host of (at times) mind-boggling instructions on limits, exceptions, and instructions for filing.