Financial Jargon Defined: Health Savings Account (HSA)

The world of finance and investments is notorious for its extensive use of jargon. With a goal to enhance financial literacy and make the world of money more transparent, we have our “monthly jargon” articles that focus on debunking financial terms that are often used sans explanation. This month, we address a health insurance term that has become a hot topic in the financial arena: health savings account (HSA). An HSA is a tax-advantaged account to help individuals with high-deductible health plans (HDHPs) – insurance plans that have higher annual deductibles than typical health plans – save for medical expenses that high-deductible plans do not cover. HSAs were created in 2003 as part of the Medicare Prescription Drug, Improvement, and Modernization Act so that individuals covered by high-deductible health plans could receive tax benefits when saving for medical expenses. Generally (with a few exceptions), any individual who is covered by a high-deductible health plan can establish an HSA.

An HSA can be used to fund qualified medical expenses today and throughout your retirement. The account is owned by you, and money deposited into the account can be invested with the potential to grow over time like money in an individual retirement account (IRA) or a 401(k). HSA contributions are made on a pre-tax basis and can be made to the account by you, the account holder, or by your employer. Funds can be used to pay for qualified medical expenses that include dental and vision care and over-the-counter drugs, to name a few. The main concept behind an HSA is that by using untaxed dollars to pay for deductibles, coinsurance, copayments, and additional qualified expenses, you, as the account owner, have the opportunity to lower your overall healthcare costs.

HSA Eligibility

You can only have and contribute to an HSA if you have a high-deductible health plan (HDHP), a type of health plan that only covers preventive services before you hit the deductible. For the plan year 2020, the out-of-pocket maximum for an HSA-eligible HDHP is $6,900 for self-only coverage and $13,800 for family coverage. Additionally, for 2020, the minimum deductible for an HSA-eligible HDHP is $1,400 for self-only coverage and $2,800 for family coverage.

It’s important to note that not all HDHPs are HSA-eligible. Insurance carriers will label if their plans are HSA-eligible, and if your health insurance plan is employer-sponsored, your HR department will be able to confirm the HSA compatibility of your plan. In addition to having an HSA-qualified HDHP, there are several other requirements you must meet to contribute to an HSA in a given year:

• You do not have any other health coverage (there are exceptions for ancillary coverage);
• You are not enrolled in Medicare; and
• You are not claimed as a dependent on another person’s tax return.

Most health insurance companies offer HSAs for their HDHPs; however, if your health insurance company does not, you can also open an HSA through certain banks and financial institutions.

How HSA-Eligible HDHPs Work

With an HDHP, for any given insurance claim, once you have paid for the portion you are responsible for, your insurance company will cover a percentage – typically 80-90% – of the remaining portion. For example, if you have an annual deductible of $1,400, and you file a medical claim for $3,000, you are responsible for the first $1,400 of the $3,000 total to cover your annual deductible. Depending on your insurance plan, your insurance company will pay a certain percentage of the remaining amount, and you will pay whatever amount is still outstanding. Once you meet your annual deductible in a given plan year, your insurance company will cover a specified percentage (typically 80-90%) of any additional medical expenses you incur, and you will be subject to cover the remaining costs. To help cover these out-of-pocket costs, you can use the funds in your HSA. A good strategy to leverage with your HSA involves setting aside a cash target, the amount of cash you want to keep in your HSA to pay for current qualified medical expenses, and then investing the remaining amount.

Main Benefits

An HSA is like a checking account that you temporarily put money you will need to pay for qualified medical expenses in; however, an HSA has many more benefits than a mere checking account. Four key benefits of HSAs include:

1. No required minimum distributions (RMDs),
2. Funds roll over every year,
3. No income limits, and
4. The triple tax-free advantages.

Triple-Tax Advantage

Arguably the most valuable parts of an HSA are the three key tax advantages that come with it:

1. Money is saved pre-tax: You don’t pay federal income tax on contributions.
2. Investments grow tax-free: When you invest a portion of your balance, you are not taxed on the earnings.
3. Withdrawals for qualifying expenses are tax-free: Paying for qualified medical expenses is tax-free whether you make the withdrawals now or in the future.   

Contribution Limits

With this triple-tax advantage comes contribution limits. For 2020, you can contribute up to $3,550 for self-only coverage and up to $7,100 for family coverage into an HSA, and there is also a $1,000 catch-up contribution for those age 55 and older. HSA funds roll over every year if you don’t spend them, so maxing out your contribution limit annually, if financially possible, is a prudent strategy to leverage the tax advantages available through these accounts.

Qualified Costs

You may be surprised by how many expenses are HSA-eligible. In addition to using your HSA to pay for doctors’ visits, copays, and coinsurance, HSAs can be used for a variety of other qualified expenses, including:

• Many fertility and maternity services,
• First-aid and health monitoring supplies,
• Drug addiction treatment,
• Certain over-the-counter medicines,
• Glasses, contact lenses, and additional vision needs, and
• Children’s health expenses, even if they are not on your health plan.

Remember, all distributions used for qualified healthcare expenses are tax-free, and withdrawals for non-qualified expenses are taxed as ordinary income and incur a 20% penalty if taken before age 65. While qualified medical expenses are always eligible for tax-free distributions, at age 65, you can also withdraw money from your HSA as ordinary income to help fund everyday expenses in retirement.

Final Points

As HSAs grow in popularity, we are seeing these savings vehicles become a key component of a holistic financial plan. These tax-advantaged accounts not only allow you to pay current bills and save for future medical expenses, but also enable you to invest in a variety of stocks, bonds, and mutual funds for potential long-term growth. With the triple-tax advantage and additional benefits, an HSA is an invaluable savings vehicle for current and future qualifying expenses, especially when it comes to managing the rising costs of health insurance.