What You Need to Know About HSAs

Health Savings Accounts: The Triple Tax Shelter, by Britton Gregory

Although they've only been around since 2003, Health Savings Accounts (HSA's) have become a common sight in employee benefit packages, and HSA-eligible plans cover about 3 in 10 employees, according to EBRI. Speaking as a financial planner, I love them, and hope that statistic goes up in the future. 

But what is an HSA, exactly? How is it similar to, and different from, an FSA? Why would you want one, why wouldn't you want one, and what's involved? 

I'm glad you asked.

The Overview

Let's go up to the 50,000 foot view. An HSA is an employee benefit whereby you can contribute pre-tax money to an account, the funds in which can be used to pay for medical expenses. However, in order to be able to contribute to an HSA, you must be enrolled in a high deductible health plan (HDHP).

That's the gist, in a nutshell. But there are lots of interesting facets that are worth diving into.

HDHPs

What exactly is an HDHP? As the name implies, this health insurance plan has a high deductible (generally thousands of dollars) and no co-pay; you pay for all medical expenses out of pocket until you reach the deductible. At that point, either the insurance pays for all of your medical expenses for the remainder of the year, or you pay a percentage of all expenses (called coinsurance) until you reach the out-of-pocket maximum, at which point further medical expenses are paid for entirely by insurance.

This may sound scary; given that a doctor's visit could easily cost $100-$200 when you take away the co-pay, even a minor illness could be a hit to your cash flow. And that's part of the idea: by forcing the consumer (you!) to bear the cost, it's supposed to encourage you to do more comparison shopping, to watch your regular medical expenses the same way you do your grocery spending. (No need to worry about your annual checkup and other preventative care, though; those are generally free.) 

While the lack of copays generally means higher out-of-pocket medical expenses, the flip side is that the premium for an HDHP is generally lower than of your employer's other offerings. So if you don't have any maintenance meds and most years you only see the doctor for that aforementioned checkup, an HDHP may make financial sense all on its own, without even considering the HSA part.  

There's another situation where an HDHP can be useful. See, while the deductible for HDHP's is often quite high, the out-of-pocket maximumis generally lower than for other plans, generally topping out at a few thousand dollars for the year. As I mentioned earlier, once you hit the OOP max, the insurance company pays every cent. If you have expensive maintenance medications, or a child that's prone to going to urgent care (personal experience!), you may find yourself paying less overall for an HDHP than you would for a normal plan! 

Any any case, if you go with an HDHP, it's important to have money set aside for medical emergencies, because your expenses on that front will be "spikey"!

HSAs v. FSAs

Hopefully, you already make use of your company's healthcare flexible spending account (FSA). What's the difference between that and an HSA?

First, in terms of what you can spend them on, they're exactly the same: most medical expenses are eligible, with the notable exceptions of insurance premiums and over-the-counter meds for which you don't have a prescription. (If you want to check a specific item that's in a gray area, like acupuncture, just google "HSA eligible expenses" and you can easily find a table with what's in and what's out.)

In terms of federal tax treatment of contributions, they're also identical: any funds contributed to an FSA or HSA are considered pre-tax, effectively reducing your tax bill. As for state income tax, well, it depends. For example, as of this writing, California exempts FSA contributions from state income tax, but not HSA contributions. 

Where they're different is in the structure of the account itself. FSA's are "use it or lose it"; any unspent contributions left over at the end of the year disappear into your employer's coffers. An HSA, on the other hand, works more like a 401(k); it persists from year to year, through changing employers, unemployment, and even retirement, and can be rolled into a new employer's HSA or left on its own, as you see fit.

The Triple Tax Shelter

And this persistence is where things get interesting. Once an HSA's balance reaches a certain threshold (generally a few thousand dollars), it can be invested in 401(k)-like mutual funds, and their growth is tax-free. And as long as any withdrawals are for qualified medical expenses, they, too, are tax-free. (Note, however, that this only applies to federal income tax; your state income tax mileage may vary.)

This triple tax shelter—pre-tax contribution, tax-free growth, and tax-free withdrawals—makes HSA's perhaps the most tax-advantaged account out there. They're like the best parts of a Traditional and Roth IRA, rolled into one!

And another great feature: once you hit 65, if you withdraw from an HSA for something other than qualified medical expenses, you're taxed on the withdrawal but not penalized. In other words, for non-qualified withdrawals, an HSA behaves exactly the same as a Traditional IRA. 

See why I love it? 

A Long-Term Strategy

Given the fact that an HSA beats out both Roth and Traditional IRA's in terms of tax advantages -- being the best of both -- a strategy worth contemplating is to treat it as a retirement healthcare account. In other words, contribute as much as you can (as of this writing, $3,500 for individuals and $7,000 for families), but continue to pay your medical expenses out of pocket, not touching the HSA until retirement.

This gives the tax savings time to compound, and again, if the "worst case scenario" occurs and modern medicine eliminates every ill known to humankind, you've still got what's effectively a Traditional IRA. More likely, though, your healthcare expenses will be a large chunk of your overall cash flow in retirement, and you'll be glad for a hefty account to draw from, tax-free. You can even use HSA's to pay Medicare premiums!

Running the Numbers

Of course, there are several variables here; as I mentioned earlier, in order to use an HSA, you also have to take on an HDHP. If your healthcare expenses fall in the middle ground -- say, you're on a maintenance medication that would be expensive under an HDHP, but are otherwise healthy -- it may be tough to weigh the short-term net cost with the potential long-term benefit. Especially since if you're currently on a copay-based plan, you probably have no idea what the actual cost of your medication is!

For me, I prefer to run cash projections (both straight-line and Monte Carlo) to determine the long-term benefit, and update them once I have at least a year's worth of data on medical expenses under the HDHP. And yes, given that I specialize in working with tech professionals, I do this a lot, alongside running the best/worst case yearly analysis on healthcare plans. Most of the time it ends up looking worthwhile, but there are a lot of built-in assumptions about spending and saving, so it's definitely something worth reviewing annually!

One thing I can say with confidence: if you don't have fully-funded emergency medical savings, be very cautious about moving to an HSA/HDHP. I know, it seems like a catch-22: you need an HDHP to fund an HSA, but I'm telling you not to take on an HDHP until you already havesavings for medical expenses! The scenario I'm trying to avoid is this: you move to an HDHP, are hit with a sudden medical expense that's larger than it would be otherwise, and you end up having to go into debt in order to pay your medical bills. Triple tax shelter or not, long-term benefits or not, that's just not worth it! If you need to take some time to build up medical savings first, by all means, do so; the tax savings can wait.