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.

Tax considerations

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.

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, so long as the plan is classified as a Section 125 cafeteria plan. In tax year 2013, the employee's share of the Social Security tax is 6.2% of gross wages, up to the Social Security Wage Base (SSWB) limit of $113,700 for 2013. Additionally, the employee pays 1.45% for Medicare taxes, with no income limit. For an employee whose gross income is below the SSWB, each dollar contributed by the employee to an HSA through a payroll deduction to an eligible plan, is exempt from the 6.2% Social Security tax and the 1.45% Medicare tax, resulting in a 7.45% tax savings. If the employee's gross income is above the SSWB, meaning he or she is already paying the maximum Social Security tax ($7,049.40), then HSA contributions have no bearing on Social Security tax; the higher-earning employee will, however, benefit by lowering the amount of income subject to the 1.45% Medicare tax.

In the table below is a comparison of two employees illustrating the effect of HSA contributions on FICA taxes. One employee earns below the SSWB and one earns above the limit. Each makes a $1,000 HSA contribution via payroll deduction to an eligible plan. An employee whose SSWB is within the phase-out of the HSA contribution would see Social Security tax savings only on the amount of the HSA contribution that falls below the SSWB.

Employee below SSWB Employee above SSWB
Gross income $100,000.00 $125,000.00
HSA contribution $1,000.00 $1,000.00
Adjusted income $99,000.00 $124,000.00
Social Security tax w/o HSA $6,200.00 $7,049.40
Social Security tax w/ HSA $6,138.00 $7,049.40
Social Security tax savings w/ HSA $62.00 $0.00
Medicare tax w/o HSA $1,450.00 $1,812.50
Medicare tax w/ HSA $1,435.50 $1,798.00
Medicare tax savings w/ HSA $14.50 $14.50
Total FICA savings w/ HSA $76.50 $14.50

In light of these calculations, for a married couple in which both spouses are eligible for an employer's HSA, if one member of the couple has a gross income below the SSWB or just above it, while the other spouse is above the SSWB, it might be advantageous for the lower-earning spouse to make all the payroll contributions to the HSA in order to reduce Social Security taxes. On the other hand, the benefit of lower Social Security taxes today needs to be balanced against the fact that a lower adjusted income will factor into the calculation of Social Security benefits in the future.

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:[1]

  • Alabama
  • California
  • 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.)

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.

If you move from a state which does not tax HSAs to a state which taxes HSAs, sell any holdings with capital gains before you move, so that you will not pay taxes on the same capital gains when you sell the same holdings later as a resident of the state. You can buy back the same or similar holdings immediately after selling.

Contribution limits

In 2014, the IRS limits are $3,300 for an individual plan and $6,550 for a family plan, plus $1,000 catch-up contributions if you are at least 55.

Withdrawals

Withdrawals for qualified 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.

Rollovers/Transfers

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 once you are age 65.

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 are 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.

Inherited HSA

Per IRS Pub 969, upon the death of the holder of an HSA, a surviving spouse may assume the HSA as his or her own if the spouse is the beneficiary.[2] The rules for a non-spouse beneficiary, however, are more complicated.[3][4][5][6]

Per Pub 969, when the HSA account holder dies, "the account stops being an HSA, and the fair market value of the HSA becomes taxable to the beneficiary in the year in which you die. If your estate is the beneficiary, the value is included on your final income tax return. The amount taxable to a beneficiary other than the estate is reduced by any qualified medical expenses for the decedent that are paid by the beneficiary within 1 year after the date of death."

See the linked referenced above for more clarification on the above terms from Pub 969. Although there is some ambiguity regarding the language around payment of the decedent's medical expenses, one matter appears to be clear: unlike an inherited IRA, an inherited HSA (to a non-spouse) ceases to become a tax-advantaged account, and it appears that reimbursable medical expenses of the decedent that had not been reimbursed no longer can be reimbursed. Hence, from an estate planning perspective, an HSA has no more value to a non-spouse beneficiary than an equal amount of cash. Therefore an HSA holder should carefully balance the desire to leave HSA funds un-reimbursed in order to compound tax-free, versus leaving behind substantial HSA balances being inherited with significant undistributed tax-free amounts. Even for a spouse HSA beneficiary, it is unclear whether the surviving spouse (who becomes the HSA holder) may distribute the undistributed expenses of the decedent.

In light of these inheritance disadvantages, "Those with both Roth IRA accounts and HSA accounts with unreimbursed qualified medical expenses, should distribute those tax-free HSA dollars before touching the Roth accounts. Also, upon turning 65 they should make distributions for Medicare Part B premiums, and other qualified medical expenses (co-pay, co-insurance, dental, vision. etc...). Tax-free HSA dollars should always be spent before Roth dollars."[7]

Advantages

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.

Disadvantages

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.

  • Eli Lilly Federal Credit Union has no setup fees and allows for commission-free trades on over 100 ETF's (including Vanguard) at TD Ameritrade once your balance exceeds $2,500, although the trades will incur a wire transfer fee.[8][9][10][11] On April 15, 2014, ElfCU initiated a $24 wire transfer fee for any transfers into TD Ameritrade.[12][13] Additionally, it will charge a $3 monthly fee effective in July 2014 if the average daily balance on the savings account side is below $2,500.[14]
  • Saturna Capital offers a stand-alone brokerage account through Pershing. You do not need a separate bank account with the HSA. There is no monthly maintenance fee. Vanguard and Fidelity Spartan funds are available for $14.95 per trade. Saturna does not offer checks or HSA credit cards.[15]
  • HSA Bank has a TD Ameritrade brokerage option which offers commission-free trades on over 100 ETF's (including Vanguard). A minimum balance must be maintained in cash at HSA Bank to avoid monthly fees. HSA Bank Rates & Fees
  • Health Savings Administrators offers 22 Vanguard funds, including Admiral shares of most index funds. Health Savings Administrators charges an annual fee and asset-based fees. Fees
  • Optum Bank Offers a suite of some 20 investment options, including the Vanguard S&P 500 Index VFINX. Monthly fee but no asset-based fee.
  • 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)
  • BenefitWallet (formerly known as The ACS|BNY Mellon HSA Solution). To use the investment platform, the participant must have at least a $1,000 balance in the HSA checking account. Any balance over the $1,000 may be invested in one of approximately 30 mutual funds[16][17]. Aside from the standard fund expense ratios, there is also a $2.90 monthly fee to use the investment platform. Of interest to Boglehead investors are Vanguard Total Stock Market Index Fund (VTSMX) and Vanguard Small Cap Index Fund (NAESX). For the checking account of the HSA, if the balance is under $3,000, then a monthly fee of $2.25 is charged. In some cases, employers may pay the participants' account maintenance fees in the checking account and/or the investment account of the HSA.

See also

References

  1. HSA State Income Tax, from HSA for America.
  2. IRS Pub 969 section "Death of HSA Holder"
  3. HSA as stealth IRA - Inheritence issue in Bogleheads.org forum, Feb. 25, 2014.
  4. Choosing Beneficiaries for Your Health or Medical Savings Account
  5. After death, is an HSA still an HSA? in Bogleheads.org forum, June 25, 2014
  6. HSA non-spouse beneficiary at Fairmark.com September 10, 2013
  7. HSA as stealth IRA - Inheritence issue in Bogleheads.org forum, Feb 25, 2014
  8. Best HSA Provider for Investing HSA Money at The Finance Buff on Jan 21, 2014
  9. HSA Bank to ElfCU for free? thread on Bogleheads.org, Jan 21, 2014.
  10. Experiences with Eli Lilly Credit Union for HSA? in Bogleheads.org forum, 14 Feb 2014.
  11. My New HSA Provider: Eli Lilly Federal Credit Union at http://yourpfpro.com, 1 April 2014
  12. Elfcu HSA Still The Best Despite New Wire Transfer Fee at The Finance Buff on April 21, 2014
  13. Elfcu HSA $24 Wire Transfer Fee at Bogleheads.org forum, 23 April 2014
  14. Elfcu HSA Adds Monthly Fee, Slipping Away From The Best at The Finance Buff on 5 May 2014
  15. my review of my HSA with Saturna brokerage in Bogleheads.org forum, 18 Mar 2014.
  16. BenefitWallet Investment Options
  17. BenefitWallet information at HSA Search

External links

IRS and Treasury

Outside links

Forum discussions

State income tax

This list is not complete, please add info for other states.

Bibliography