Health Savings Account
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A Health Savings Account (HSA) is a special account which is used in conjunction with a high deductible health plan. Contributions to the account are tax-deductible on the federal and most state tax returns, and withdrawals are tax-free if they are used for medical expenses. Unlike a flexible spending account, unused money remains in the account and can be invested; most accounts offer either mutual funds or brokerage accounts for investing.
Basic HSA Rules
You are only eligible to contribute to an HSA if your only health insurance is a qualified high deductible health plan, although you can continue to use and withdraw from the HSA once you are no longer eligible to contribute. Unlike most health insurance, the high deductible health plan pays nothing except for preventive care until you meet a fairly high deductible. The plan may make its own contribution to the HSA in order to reduce your potential out-of-pocket costs. Unlike many other tax deductions, there are no income restrictions to contribute to an HSA. Contributions to an HSA reduce your federal adjusted gross income (AGI) dollar for dollar, possibly making you eligible for income-based credits or Roth IRA contributions you would not otherwise be eligible for without the HSA deduction.
In 2013, the IRS limits are $3,250 for an individual plan and $6,450 for a family plan, plus $1,000 catch-up contributions if you are at least 55. If your employer allows it, you can make your own contributions through pre-tax payroll deduction; this has the additional advantage that these contributions, like pre-tax insurance premiums, are not subject to Social Security and Medicare taxes.
Withdrawals for qualfiied medical expenses (as outlined in IRS Publication 502, Medical and Dental Expenses) are tax-free. As long as you keep proper records, you can even reimburse yourself in a later year for medical expenses which you paid out of pocket after you established the HSA (see Q39 in IRS Notice 2004-50). Withdrawals for other purposes are taxed at your full tax rate, with an extra 20% penalty. The penalty is waived if you are at least 65 or disabled, and if you die and do not leave the account to a spouse, the account is distributed with tax but with no penalty.
State taxation of HSAs
While contributions are deductible on one's federal income tax, this is not always true for state income tax. The following states are not in conformity with federal legislation and do not recognize HSAs, so contributions are not deductible and earnings are taxable:
- New Jersey
If you live in a state which taxes HSA earnings, consider investing the HSA in Treasury bonds or TIPS, which are exempt from state taxes. (In some states, capital gains issued by a TIPS/Treasury mutual fund or capital gain/loss on the sale of Treasury mutual fund shares would be subject to state taxes, but even if they are, most of the returns from Treasury bonds and TIPS would be income which is not subject to state tax.) Also in states that tax contributions, be aware that Federal tax-free rollovers into an HSA, such as the once in a lifetime IRA to HSA rollover, and an Archer MSA to HSA rollover, are treated as a non-qualified withdrawal from the IRA/MSA at the state level and subject to income taxes and penalties on the state return. Also, in states that tax contributions, the state treats the HSA as a taxable account, taxable investing rules apply. Principles of Tax-Efficient Fund Placement are important, except when investing in TIPS and treasury bonds (as noted above) and Tax Loss Harvesting is possible on the state tax return if you have capital gains or the state allows carryovers of capital losses. HSA administrators are not required to send you tax forms (such as 1099-INT, -B) by the IRS, so you are required to keep good records, track the state cost basis manually, and report HSA gains/losses on your state tax return. You may be able to include amounts paid from the HSA for medical expenses as an itemized deduction on the state tax return, subject to AGI floors.
You can make a once in a lifetime rollover or transfer from an IRA to an HSA up to the annual HSA funding limit. This is usually not advised since you would lose the ability to contribute and take an HSA tax deduction for the amount you transfer, but it can be an emergency source of funds without paying taxes or penalties. See IRS Notice 2008-51.
You can rollover an Archer MSA to an HSA as stated in IRS Pub. 969 page 6.
Also it is not advised if you live in a state that taxes HSA contributions to do either of these rollovers, due to incurring state taxes and penalties.
You are able to move money between HSA custodians through direct rollovers and trustee to trustee transfers - see IRS Pub. 969 page 6. The rules are exactly the same as IRA Rollovers and Transfers. You may want to do this annually if you contribute to a plan through your employer's payroll deduction to gain the social security and medicare payroll tax exemption, but you don't want to leave the funds there long-term if the investment options are not good. The HSA custodian(s) may charge a fee for a trustee-to-trustee transfer; direct rollovers can usually be done without a fee.
How the account operates
The HSA custodian is a bank, and the account initially works like a bank account; you can make deposits, and withdraw money with checks or a debit card. Once you have enough money in the account, the bank allows you to link the account to a mutual fund or brokerage account; you still write checks against the bank account,and must transfer money to the bank account in order to use it.
You can choose your custodian, and transfer accounts between different custodians. However, if your health plan or employer makes a contribution, it may select the custodian to which it makes contributions, and may offer other incentives such as waiving service fees.
How to use the plan
There are two ways to use the HSA; you can either pay all your medical expenses from it, or pay out of pocket and save the plan money for medical expenses in retirement.
Paying current expenses from the HSA
If you are not maxing out your retirement accounts, you should usually pay current expenses from the HSA. If you are in a 25% tax bracket and have $1,000 in medical bills, taking $1,000 from the HSA, and taking advantage of the fact that this wasn't an out-of-pocket expense so that you can invest an extra $1,000 in your Roth IRA or $1,333 in your 401(k), works to your benefit.
If you kept the $1,000 in the HSA and paid the expense out of pocket, you would have the right to withdraw $1,000 from the HSA later to cover the expense and spend $1,000 on anything later. But if you invested the $1,000 in a Roth IRA, you gained the right to spend not only that $1,000 on anything in retirement, but also the gains on that $1,000; if you invested $1,333 in a 401(k), that is just as good after adjusting for the 25% tax you will pay in retirement.
Because of the tax deduction, you should invest in the HSA in preference to any other retirement savings except for a contribution matched by your employer. If you are in a 25% tax bracket, $1,000 invested in your 401(k) costs you $750 out of pocket, but you will lose much of the money to taxes when you withdraw it. $1,000 invested in the HSA costs the same $750 out of pocket but can be spent tax-free as long as it is used for medical expenses. In addition, HSA contributions via employer payroll deduction are exempt from FICA taxes, where 401(k) contributions are not.
If you are too healthy in retirement and can't use the HSA for medical expenses (even past ones), the non-medical portion is still as good as a traditional IRA.
Paying current expenses out of pocket
If you are maxing out your retirement accounts, you should treat the HSA as an opportunity for further savings, like an IRA, and not withdraw from it until you retire. If you have $1,000 in medical bills, paying them from your taxable account leaves the $1,000 in the HSA to grow tax-free (and keeps the right to withdraw $1,000 tax-free in a future year), while paying them from the HSA leaves $1,000 in your taxable account, which will grow subject to taxes since you do not have any room for tax-sheltered contributions.
Once you have retired, you can withdraw from the HSA an amount equal to your past medical expenses plus any current expenses tax-free, and withdraw from your other accounts for non-medical expenses. HSAs can be used to pay medicare premiums and other medical expenses in retirement.
As with a flexible spending account, the HSA allows you to contribute tax-deductible dollars and spend them tax-free on medical costs. However, money in a flexible spending account is lost if not used within a grace period after the end of the year, so you can only use it for expected expenses and will pay unexpected medical expenses with after-tax dollars. The HSA allows you to pay all your expenses with pre-tax dollars as long as they fit within the HSA limit, and what is not used continues to roll over to following years.
If your employer gives a percentage subsidy on health insurance, the insurer's contribution to the HSA benefits from the same subsidy. For example, if your employer pays 75% of your health insurance, it costs you only $250 to receive benefits which cost the insurer $1,000, even if that $1,000 benefit is a contribution to your HSA.
The main potential disadvantage of the HSA is not the account but the high-deductible plan which goes with it. If you have very low expenses, the high deductible doesn't matter; if you have very high medical costs, the plan must have a catastrophic maximum out-of-pocket cost which may also save you money. If your expenses are near the deductible, you may be better off without the HSA, using a conventional plan instead. HSAs are still relatively new in existence and are generally not available from major fund companies and often have maintenance fees.
HSA custodians and options
This list is not complete; please add others.
- Health Savings Administrators offers 22 Vanguard funds, including Admiral shares of most index funds. Fees
- HSA Bank has a TD Ameritrade brokerage option with no-commission ETF trading, and a separate option with mediocre mutual-fund choices. HSA Bank Rates & Fees, TD Ameritrade commission and fees. (HSA Bank recently eliminated their set-up fee). TIP: Avoid mutual fund commissions at TDAmeritrade by setting up Automatic transactions, in which there is no commission for automatic investing of mutual funds. Using this form, this is the lowest cost HSA custodian to buy Vanguard mutual funds - $2.50/month maintenance fee, or no fees if $3,000 held in cash at HSA bank; plus $3.00/month investment fee, or no investment fee if $5,000 is held at HSA bank (as of January 2011). Update 10/11/2010: TDAmeritrade recently dropped ETF commissions for long-term investors. (A long term investor is one who holds the ETF longer than 30 days)
- The Bancorp Bank HSA is directly linked to a National Financial Services (subsidiary of Fidelity) brokerage account; the commissions for trades are fairly high but you do not need to have a separate money-market fund in your brokerage account. Bancorp no longer offers individual plans.
- The Sterling HSA offers full-service medical record keeping with the Standard Plan, and the ability to use any brokerage account which is willing to open an account in the name of "Sterling HSA for The Benefit of (account holder)"when using the eSavings Plan. Sterling HSA Fee Schedule (there is an additional $16 annual fee for using their brokerage)
- Saturna Capital offers a stand-alone brokerage account; you do not need to save a separate bank account with the HSA. The commissions are moderate; the TD Ameritrade account from HSA bank has lower commissions but may cost more because of the need to have a separate bank account if you are an infrequent trader. Saturna HSA information
IRS and Treasury
- IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans
- IRS Publication 502, Medical and Dental Expenses (HSA-qualified expense list)
- IRS Notice 2004-2 Health Savings Accounts (HSAs)
- IRS Notice 2004-50 Health Savings Accounts: Additional Q's and A's
- US Treasury: Health Savings Accounts
- HSA Wikipedia page
- HSAs and HRAs See Growth Over Four-Year Span, by EBRI.org
- The Complete Consumer's Guide to HSAs, by HSA for America
- HSA for America Maximize your HSA Newsletter
- Health Savings Account Contribution Limits for married couples according to type of coverage, by SunTrust
State Income Tax
This list is not complete, please add info for other states.
- Instructions for filling out your CA state tax return if you have an HSA
- Total amount of CA income tax paid on HSAs to date, calculate your share
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