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Health Savings Account - Everything you need to know

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Health savings accounts (HSAs) are a tax-advantaged way to save for out-of-pocket medical expenses. But HSA accounts can be even more valuable if you know key strategies. 

HSAs provide a triple tax break:

  • Your contributions are tax-deductible (or pre-tax if through your employer)
  • The money grows tax-deferred
  • HSA money can be withdrawn tax-free anytime for eligible medical expenses. 

An HSA can be a great place to keep emergency money for unexpected medical bills. Plus, an HSA can build up tax-free savings to help cover medical expenses in retirement. 

Fidelity estimates that a 65-year-old couple retiring in 2020 will pay an average of $295,000 in health care costs over their lifetime. That money includes Medicare premiums, deductibles and copayments, which can all be paid tax-free with money from an HSA. Find out more about copays, coinsurance, deductibles and out-of-pocket costs.

"HSAs are probably the best long-term savings vehicle," says Anastasia Krymkowski, associate director of retirement for financial research firm Cerulli. "They're one of the best places for your money -- even above contributing more than the employer match to your 401(k)."

But many people don't take advantage of an HSA -- and there are many misconceptions about the accounts. 

One common mistake is confusing an HSA with flexible spending accounts (FSAs). Many employers offer FSAs, which allow you to keep a savings account to pay for health care needs that year. FSAs don’t allow you to roll over money into the next year.

That’s not the case with HSAs. There are no use-it-or-lose-it rules for HSAs. Instead, an HSA lets you keep the money growing in the account and withdraw it tax-free at any time for eligible expenses. 

"There is no timeline for reimbursing yourself and the money is never at risk of being forfeited," says Roy Ramthun, president of HSA Consulting Services, who led the U.S. Treasury Department's implementation of HSAs after they were enacted in 2003.

Here's what you need to know to make the most of HSA benefits, and some key points to consider when deciding whether to choose an HSA-eligible health insurance policy during open enrollment.

 

What's a health savings account?

An HSA is a tax-advantaged account you can tap into tax-free to pay out-of-pocket health care costs, including your deductibles, copayments, prescription drugs and other eligible medical expenses that aren't covered by insurance.

HSA contributions are available for people with a high-deductible health plan (HDHP) plan. These plans have a deductible of at least $1,400 for single coverage or $2,800 for family coverage in 2021. Your employer may offer an HSA-eligible policy or you can buy a policy on your own. 

Here’s how much you can contribute to an HSA annually:

  • $3,600 if you have single coverage
  • $7,200 if you have family coverage
  • If you're 55 or older, you can contribute an extra $1,000 for the year

Most employers offer HSA-eligible policies -- 89% of the large employers surveyed by the Business Group on Health plan to provide an HDHP in 2021, including 22% that are giving an HDHP as the only option. 

Employers that offer HDHPs often pair them with an HSA and make it easy to enroll in the account. You can make pre-tax contributions through payroll deduction. 

Most employers automatically contribute money to the HSA for all employees who choose the HDHP. Business Group on Health said employers will provide a median contribution of $600 for employees (and more for families) in 2021.

If you buy your own health insurance, or if your employer doesn't offer an HSA, you can sign up for an HSA yourself as long as you have an eligible health insurance policy. Many banks, brokerage firms and other financial institutions offer HSAs. To find a list of HSA providers, see https://www.hsasearch.com/.

People with Medicare aren’t eligible to make new HSA contributions. However, you can keep the money growing in the account and use it tax-free for even more expenses after you turn 65.

 

HSA tax breaks

The HSA's tax advantages may make it even more valuable than a 401(k) or IRA because you get a tax break on both the front and back end. The money you contribute is tax-deductible or pre-tax, it grows in the account tax-deferred and then you can use it tax-free for eligible medical expenses.

However, you'll have to pay a 20% penalty and taxes on the withdrawal if you withdraw money from the HSA for a non-eligible medical expense. After age 65, the 20% penalty goes away, but you'll still have to pay taxes on non-eligible withdrawals.

But there are so many ways to use the money for eligible expenses -- and even more health care costs qualify after you turn age 65 -- that it's easy to avoid having to pay the tax bill and penalty if you plan carefully.

"I think of my HSA as a second retirement account," says Krymkowski. "Why would I touch it because it's growing tax-free? I'll have at least that much in medical expenses down the road."

 

HSA rules

You can use the HSA money tax-free for health insurance deductibles, copayments and other out-of-pocket medical expenses, including prescription drugs.

You can also use the money tax-free for vision and dental care, and other eligible expenses that aren't covered by your health insurance, such as hearing aids, chiropractor visits and therapy received as medical treatment.

People can also now make tax-free withdrawals for over-the-counter medications and feminine hygiene products. 

You can withdraw money tax-free from the HSA to pay health insurance premiums if you're receiving unemployment benefits. You can also use HSA money to pay COBRA health insurance premiums if you lose your job, even if you aren't receiving unemployment benefits.

And the list of eligible withdrawals expands after you turn age 65. At that point, you can also withdraw HSA money tax-free to pay premiums for Medicare Part B, Part D prescription drug and Medicare Advantage plans.

You can additionally withdraw money tax-free from an HSA to pay a portion of eligible long-term care insurance premiums based on your age. 

Tax-free withdrawal limits for long-term care insurance vary by age:

  • Up to $430 if you're age 40 or younger
  • $810 if you're 41 to 50
  • $1,630 if you're 51 to 60
  • $4,350 if you're 61 to 70 
  • $5,430 if you're 70 or older

Your spouse can withdraw up to those limits, too.

 

How does an HSA work? 

You can withdraw money from your HSA for out-of-pocket medical expenses at any time. Some people tap into the account whenever they have health care costs throughout the year. Many HSA administrators provide debit cards to make it easy to use the money. But you don't have to use an HSA card right away. 

If you have other cash available for current medical expenses, you can keep the money growing in the HSA and get a bigger tax benefit when you use it for future medical expenses.

It's important to keep the HSA benefits in mind when deciding whether to choose an HDHP plan during open enrollment.

"Step one to having an HSA is being in a high-deductible plan, and I think there's a misconception that high-deductible means more expensive," says Krymkowski. 

It's vital to compare premiums and out-of-pocket expenses, plus any HSA contribution from your employer, as well as the benefits of the tax-deductible contributions. 

"Even those who use a lot of medical services might be surprised to find that a high-deductible plan could be the better option for them," she says.

Many financial advisors recommend contributing to an HSA as one of your top savings priorities.

"For someone who has emergency savings and a stable situation, the traditional advice I would give is first contribute enough to your 401(k) to maximize your match, then max out your HSA because that is even more tax-advantaged," says Krymkowski.

Ramthun says a common mistake he sees is people who only contribute enough to the HSA to cover their deductible or the expenses they know they'll incur that year. So, they’re using HSAs like an FSA when they should consider long-term health costs. 

"Every dollar contributed provides a tax deduction (or may be tax-free), and you never know what the future holds for medical needs, including losing one's job and health insurance," he says. "Most of us can count on spending more on health care in retirement, so it's best to start saving for that as soon as you can and let the power of compounding do its thing."

If you're going to keep the money growing in the HSA for the long-term, make sure your investments match your timeframe. Most HSA administrators offer several mutual fund choices for long-term investors, but some only provide a low-interest savings account. The fees and investment options can vary a lot by plan. 

"Investment options usually have fees, so it pays to shop around," says Ramthun.