Health savings account

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, 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.

Basics
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.

In 2010, the IRS limits are $3,050 for an individual plan and $6,150 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 medical 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 10% 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.

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.

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.

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.

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.

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.

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


 * OptumHealth Bank is a plan which offers 11 Vanguard funds; the bank offers other plans as well but the mutual funds are not very good. Fee Schedule


 * HSA Bank has a TD Ameritrade brokerage option, and a separate option with mediocre mutual-fund choices. HSA Bank Rates & Fees, TD Ameritrade commission and fees.


 * 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. The Bancorp's fee schedule


 * Vanguard: Health Savings Accounts Page