In show-business, few can claim that they are the much sought after triple threat. While many can sing and dance, or act and sing, few stars can sing, act, and dance exceptionally well.
In the retirement savings world there are many different accounts that offer tax benefits. But just like many stars, they only offer two of the three tax-preferential benefits. For instance, a Roth IRA allows invested money to grow tax deferred and be withdrawn tax-free, but does not allow a tax deduction for contributions. On the other hand, a 401(k) plan allows a tax deduction for contributions and grows tax deferred, but the money gets taxed upon withdrawal.
When it comes to tax-preferential savings there is one account that can sing, dance, and act above the rest. This ever elusive triple threat of the retirement savings world is none other than the Health Savings Account (HSA). This is the only current savings vehicle that offers a tax deduction for contributions, tax deferred growth, and tax-free withdrawals for qualified distributions. The question is, are you eligible to contribute to an HSA which is beloved by so many financial planners? In this post we will explore how HSAs work and the eligibility requirements for contributing to one.
Who can contribute to a Health Savings Account?
Before we dive into the incredible tax benefits and uses of an HSA, we first need to address who is eligible to contribute. There are four main requirements for eligibility from the IRS1:
You are covered under a high deductible health plan (HDHP) on the first day of the month
You have no other health coverage except what is permitted under other health coverage
You aren't enrolled in Medicare
You can't be claimed as a dependent on someone else's tax return
What is considered a high deductible health plan (HDHP)?
There is much confusion when it comes to what is considered a high deductible health plan. For the coming year, 2020, those are plans with a minimum deductible of $1,400 for an individual or $2,800 for family coverage and with a max out of pocket of up to $6,900 for individual or $13,800 for family plans (for in-network coverage).2
While the deductible may be higher than other plans, that does not necessarily mean that you will have to pay everything out of pocket before you get some benefits from your insurance. The HDHP can cover some preventative care procedures without disqualifying it for HSA contribution purposes. Things like routine exams, some screening services (ie: cancer screening, heart vascular diseases, etc.), and some mental health conditions are allowable just to name a few. A full list of eligible screening services can be found on the IRS website by following this link.
It's important to reiterate that the deductible and out of pocket thresholds only apply to in-network care. Many health insurance policies differentiate in-network care with some doctors and hospitals where they have negotiated a relationship and out of network care with doctors and hospitals they have not. Out of network care generally has higher deductibles and out of pocket maximums if it's even covered at all!
This can also get a little more tricky when it comes to family plans. Family plans typically have two deductible amounts, one for each individual covered by the plan, and one for the entire family. The individual deductible and family deductible need to be at least the minimum deductible ($2,800 for 2020) in order to qualify. As an example, if a family plan had a $2,000 deductible per individual and a total deductible of $3,500 the plan would not qualify, because the individual deductible is less than the minimum of $2,800 for 2020.
What about other health coverage?
Generally, if you're covered by a high deductible health plan you aren't allowed to carry any other form of coverage. There are exceptions for the following additional coverage, including1:
There is another, albeit unusual, way for someone to qualify and that's by not being covered by your spouse's plan. If your spouse does not have a HDHP, and you are not covered by it, but have your own HDHP you would be eligible while your spouse would not. Also, if you are covered by a Flexible Savings Account (FSA) or Health Reimbursement Account (HRA) even if you have a HDHP, depending on what is covered, you may not be able to contribute to a HSA.
How do you know for sure if you're eligible?
These rules can get quite complex and convoluted. By far the easiest way to know if you're eligible is simply asking your insurance company. Many insurance companies deliberately design plans to be HSA eligible or not and include the word “HSA” or “Saver” in the name of the plan. If you're unsure, just ask and they should be able to give you a clear answer. Just because your plan has a high deductible does not mean it will qualify as an HSA-eligible plan. It is very important not to contribute to an HSA unless you qualify.
How does an HSA work?
Now that we've gone over much of the qualification guidelines, we can dive into the exciting stuff . . . How exactly do HSAs work? There are a few steps in the process.
Assuming you're eligible, the first step is contributing to a Health Savings Account. Most of the time this is done through a payroll deduction, similar to how a 401(k) contribution or taxes are automatically withheld from your paycheck. Just like a 401(k) contribution, the money set aside in an HSA is not taxed yet (possibly never!) and is not reported as earnings for tax purposes. Therefore, if you're in the 25% tax bracket and make a $1,000 contribution to your HSA, you just saved $250 on your taxes right off the bat!
The immediate tax savings are nice, but the “fun” (for financial advisors at least) doesn't end there. Now that you have some money in your HSA you have some options on what to do with it. Contributions go in as cash, just like your checking account. However, most HSA accounts give you an option to invest some, or all, of the money. When the funds are invested any income that is earned in for the form of interest or dividends, or if you sell an investment for a profit (capital gains), none of that income is taxable to you while it's inside the HSA. That's why it’s also considered tax deferred.
While it's all well and good to save, what's the point if you never use it? Like most retirement savings accounts there are restrictions to when you can use the money without a penalty. The same is true for a health savings account. However, if you withdraw money for a qualified health expense, any money taken from the account is tax-free. It's important to note that if you withdraw money for a non-qualified expense that the money withdrawn is subject to income taxes, and an additional 20% penalty. Assuming you're in the 25% tax bracket and withdraw $1,000 for a non-qualified expense, $250 would be owed for income taxes and $200 for the penalty ($450 total). A steep price to pay for not using the funds for a qualified expense.
What are qualified HSA Expenses?
These are qualified medical expenses that are paid for you, your spouse, or any of your dependents (typically children). HSA bank, a HSA account provider, provides an extensive list of current qualified expenses. Qualified expenses range from prescription drugs to acupuncture and even guide dogs! Most usual and routine medical costs will be eligible from an HSA. For a full list of qualified expenses you can read IRS Publication 502.
What about distributions in retirement?
The goal of using HSA funds is for medical expenses. However, something interesting happens when you turn 65. After age 65 you can withdraw money out of your account for any reason, without incurring the 20% penalty. You would still owe income taxes on distributions, unlike if it was used for medical expenses. But this is a good option for those who have stellar health insurance in retirement and are not expected to use all of their HSA for medical expenses.
How much can you contribute to an HSA?
If financial planners had it our way, we would not impose any limits on HSA contributions because of the incredible triple-tax benefits. However, like most things in life, that would be too good to be true. Like other retirement savings plans, the IRS imposes contribution limits on HSAs as well. For 2020, the limits are $3,550 for individuals and $7,100 for family plans, a small increase from $3,500 and $7,000 in 2019.
Another benefit is that for those who are 55 and older (not 50 like other retirement plans!) they can make an additional contribution of $1,000 to their HSA. If both spouses are over 55, they each can make an additional $1,000 contribution. Since HSA accounts are opened in an individual's name, if you're over 55, and covered by a family plan, the spouse who owns the plan would be able to make an $8,100 contribution in their HSA, and the other spouse over 55 could contribute $1,000 to their own HSA.
If you didn't max out your 2019 contributions but want to because you now know of the awesome tax benefits, you're in luck! Just like with IRAs, you can make your 2019 contribution through the tax filing deadline of April 15th of 2020.
We hope you now know why HSAs have financial advisors singing and dancing (and acting!) about their awesome tax benefits. While there are many tax preferential saving tools out there, there is currently only one with a triple-tax benefit. If you're eligible to contribute to an HSA, and you aren't currently maxing it out, you likely should start.
As always, for further questions about HSAs and their workings we suggest you speak with a financial planner or tax professional.