ADVANTAGES AND LIMITATIONS OF HSAs
SUMMARY
For eligible individuals and families, health savings accounts can offer benefits beyond tax-free qualified distributions, but there are a few factors to consider before investing.
WHAT IS AN HSA?
Health savings accounts, or HSAs, are accounts in which contributions are tax deductible and growth and qualified distributions are tax free. That’s right—you get a deduction for contributions and you don’t have to pay taxes on investment growth or when you make a qualified withdrawal.
Tax free sounds too good to be true, doesn’t it? As you can imagine, HSAs have some constraints. Only individuals or families with a high-deductible health plan (HDHP) with no other health coverage are qualified to open a health savings account. According to the IRS, HDHPs are defined as health insurance policies “with an annual deductible that is not less than $1,400 for self-only coverage or $2,800 for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $7,000 for self-only coverage or $14,000 for family coverage.”1 Furthermore, qualified HSA withdrawals are restricted to the definition of medical expenses, which is, at least, rather broad and includes both prescription and some over-the-counter medications. Yearly contributions to the HSA are capped for 2021 at $3,600 ($7,200 for a family) and must be made by the federal tax return due date. If you’re age 55 or older, you can contribute an additional $1,000 as catch-up, similar to an IRA.
For some people, HSAs are a great opportunity to minimize taxes and maximize flexibility. Here, we break down the benefits—and limitations—of this versatile asset.
BENEFITS
FUNDS CAN BE INVESTED
In spite of their name, health savings accounts can act more like investable IRAs or brokerage accounts. While some HSA providers require a minimum balance before allowing investing, not all do, and you can choose your portfolio based on your own goals and risk tolerance from a variety of investment options, which can include stocks, mutual funds, bonds, and annuities. Investing your account may help to limit the impact of inflation as well as offer the potential for growth that can pay off later when you need to access the funds.
EMPLOYERS CAN CONTRIBUTE
If your employer offers an HSA as part of its employment benefits, it can also contribute to the account. Contributions made by employers are tax-deductible to the employer and may be excluded from your gross income, which incentivizes them to offer HSAs, though contributing is not a requirement. Note that the annual contribution limit of $3,600 encompasses all contributions, including those from the employer. If you leave your employer or the workforce, your HSA goes with you.
INDIVIDUALS CAN OPEN THEIR OWN HSA
Not every company offers an HSA. As long as you have an HDHP, however, you can open your own HSA without worrying about employer sponsorship. You can deduct your contributions even if you don’t itemize deductions, which may help offset some of your tax liability. Compare different HSA providers on account minimums, management fees (some charge no fees), and range of investment options to find a custodian that fits your needs.
BALANCE IS CARRIED FORWARD YEAR TO YEAR
Unlike with flexible savings accounts (FSAs), the balance in your HSA does not have to be spent down by the end of the year. Instead, it carries forward indefinitely, moving with its underlying investments and growing with future contributions.
IMMEDIATE WITHDRAWALS NOT REQUIRED
As it stands with current legislation, if you incur a medical expense, there is no time limit on your withdrawal. You can wait as long as you want to take a withdrawal from your HSA to pay for a qualified medical expense. This can mean giving your funds years—maybe even decades—to grow before withdrawing the expense’s corresponding amount from your HSA. You will need to have documentation to justify the withdrawals, however, so be sure to maintain your records.
NO MINIMUM DISTRIBUTION
One of the downsides of traditional IRAs is that minimum distributions are required at age 72, whether you need the money or prefer to let it grow. HSAs, while they operate very similarly to IRAs, do not require you to take out a certain amount at a particular age. This gives you significantly more flexibility in handling your distributions from the account.
LTCI AND MEDICARE PREMIUMS QUALIFY
Long-term care insurance premiums can be pricey, and not all aspects of Medicare are free. HSA funds, happily, can be used to pay for either. In fact, HSAs can pay for a wide variety of medical expenses beyond exams, treatments, and surgeries, including deductibles, long-term care, eye exams and corrective treatments, hearing aids, wheelchairs and crutches, chiropractors, and insulin, just to name a few.
NO PENALTY FOR AFTER-65 NONQUALIFIED WITHDRAWALS
Nonqualified withdrawals will incur a 20% penalty. This penalty, however, sunsets when you turn 65. At that point, any nonqualified withdrawals you make will be taxed to you as ordinary income, the same way that traditional IRA distributions are taxed. You will continue to receive all of the tax advantages if you make qualified withdrawals.
PASS TO SPOUSE LIKE AN IRA
If you die before you can use your entire HSA, your spouse will inherit it as his or her own account without triggering a taxable event, like a traditional IRA. This means that he or she doesn’t have to take mandatory distributions, can use the funds tax free for qualified expenses, and can make nonqualified withdrawals at ordinary income tax rates if over age 65.
BYPASSES PROBATE
Because you assign beneficiaries to your HSA, in the event of your passing the account will bypass probate and go directly to your heir(s).
LIMITATIONS
HSAs thus far offer a compelling option for those who qualify to contribute to one, but what about those restrictions we mentioned earlier?
MUST HAVE AN HDHP
The largest constraint, of course, is that you have to have an HDHP to be eligible to open an HSA in the first place. Check with your insurance provider to verify your eligibility. If you lose your HDHP, you don’t lose your rights to your existing HSA, including the ability to invest or withdraw from it. However, you are no longer permitted to make contributions to it. If you return to an HDHP at some point, you can resume contributions again.
NONQUALIFIED WITHDRAWAL PENALTY
As mentioned above, withdrawing funds for nonqualified expenses comes with a hefty 20% penalty. This is mitigated by the age 65 threshold, when you can take nonqualified withdrawals at ordinary income tax rates. Nonetheless, it is important to plan your cash flow and reserves to keep you from ending up in a position where you have to take the penalized funds.
NO ITEMIZED DEDUCTIONS FOR HSA-PAID MEDICAL EXPENSES
If you pay for your medical expenses using funds in your HSA, you cannot also include those expenses in your itemized deductions (to itemize, your deductible expenses must exceed 7.5% of your adjusted gross income). Since you have already deducted your HSA contributions when you first made them, deducting expenses paid for by the HSA would be double-dipping and is not permitted. The IRS, in audits, will look for this.
EXPENSES MUST BE INCURRED AFTER OPENING HSA
Unless medical expenses were incurred after the HSA was fully established, they are not considered qualified expenses. This means that you can’t have a large medical bill, establish an HSA later to help pay for it, and then withdraw HSA funds to reimburse those expenses without triggering the 20% penalty (or income tax if over 65). You can, however, pay for medical expenses incurred after the HSA was established with funds that were contributed after the expense.
MUST KEEP EXPENSES ORGANIZED
This may seem like a minor factor, but the records that need to be kept for your HSA will span years and possibly even decades and are crucial for using your HSA well. It is necessary to meticulously store and organize your bills and receipts that define the service, treatment, or product for which you incurred a qualified medical expense. If you are audited by the IRS, they will expect to see proof of the nature of the expense for which you took a qualified HSA withdrawal. Many people scan their documents and store them digitally. If you decide to maintain original paper files, be mindful that some receipt papers will fade with time.
NON-SPOUSE BENEFICIARIES TAKE A LUMP SUM
One of the downfalls of an HSA is, perhaps, its inheritance structure. While spouse beneficiaries will continue to receive the tax benefits of an inherited HSA, non-spouse beneficiaries do not. Limited payout options exist for non-spouse beneficiaries, which generally means the HSA becomes a taxable account. Consequently, the inherited amount—minus the decedent’s medical expenses paid within one year of death—is taxed all at once to the beneficiary as ordinary income. Another, but not necessarily better, option is to assign the estate as the beneficiary of an HSA. In this case, the full amount of the HSA, minus the decedent’s medical expenses paid within one year of death, is counted as a distribution and included on the decedent’s final tax return. For more information, please consult a tax professional.
THE IMPORTANCE OF PLANNING
Health savings accounts are great tools that, when coordinated with the other moving parts of your financial plan, can provide flexibility and tax advantages. Reach out to us at Day Hagan, and we can help you determine if it makes sense for you to contribute to an HSA.
Best,
Natalie Brown, CFP®
Director of Client Services
Day Hagan Private Wealth
—Written 8.20.2021.
1 From the IRS’s Revenue Procedure 2020-32.
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