Slowly but surely, the public is starting to become aware of health savings accounts (HSAs) and the impact they can have for uninsured people who qualify for them. This relatively new type of medical savings account allows for tax-deductible contributions and tax-free distributions as long as the money is used to pay for qualified medical expenses.

Any unused funds in these accounts eventually can be withdrawn as retirement income. Therefore, they not only can provide a means to pay for medical insurance and expenses, but also can function as an additional avenue for retirement savings. (To learn more about saving for retirement, see our Retirement Planning Basics tutorial.) In this article we'll show you what you need to qualify for these accounts and if they are right for you.

Qualifications for HSA Eligibility

The basic requirements that must be met to open one of these accounts are as follows:

  1. Neither the account holder nor his or her spouse can have access to any other type of standard group health insurance coverage (but coverage for dependents is allowed). Whether the account holder or spouse actually participates in the other plan is irrelevant; eligibility for the plan alone will disqualify them from health savings account participation. Medicare coverage for either spouse will also disallow contributions for that spouse, although such things as prescription discount cards are permitted. In some cases, veterans are also excluded from opening health savings accounts. (Read more about Medicare in Fighting The High Costs Of Healthcare,Medicare: Defining the Lines and Getting Through The Medicare Part D Maze.)

  2. The account holder must also purchase a qualifying high-deductible health insurance policy (HDHPs) that has a minimum deductible of $1,100 for singles or $2,200 for families. High-deductible health policies are structured specifically to pay only for major or catastrophic medical expenses. The annual out-of-pocket copays cannot exceed $5,500 for singles or $11,000 for families. These policies are allowed to have first-dollar coverage for preventive care and higher limits for non-networked expenses. Catch-up contributions are also available for those aged 55 and up. The catch-up contribution limit is $800 for 2007, $900 for 2008 and $1,000 for 2009 and beyond. (To find out more, see Retirement Savings Tips For 45- To 54-Year-Olds.)

  3. For 2007, the contribution limits for health savings accounts are $2,850 for singles and $5,650 for families. These limits will increase to $2,900 for singles and $5,800 for families in 2008. The contribution amount is allowed to exceed the deductible from the policy. (It should be noted here that the health savings account itself is separate from the actual high-deductible health insurance policy that must be purchased to qualify for it.) While a contributor can make the contribution at any time during the year in any amount desired within the prescribed limits, the financial institution administering the account may impose a minimum required deposit or current balance.
  4. Many different financial institutions such as banks, credit unions, brokerage firms and insurance companies offer these plans, and the number is rapidly growing.

Tax Benefits of HSAs
Once the requirements have been met, however, health savings accounts provide the following tax advantages:

  1. All contributions made to these accounts are classified as above-the-line deductions on the taxpayer's 1040, just like IRA or other retirement plan contributions. Itemization of deductions is therefore unnecessary.
  2. Because long-term care insurance is considered a qualified expense under these plans, all premiums paid for a tax-qualified policy become deductible within certain limits, as long as the account holder is age 65 or above. Regular health and medical insurance premiums can also be deductible for those under 65 who are unemployed. (Keep reading on this subject in Long-Term Care Insurance: Who Needs It?)

  3. All distributions from health savings accounts that are used to pay for qualified medical expenses are tax free. For the purpose of health savings accounts, "qualified medical expenses" has an extremely broad definition, encompassing everything from over-the-counter drugs to acupuncture and other esoteric remedies, as long as they are not for cosmetic treatment. Furthermore, the money contributed to the accounts can be invested (the types of investments permitted are the same as for IRAs). This means that over time, it is possible to achieve tax-free income generated solely by the investment portfolio within the account.
  4. A one-time transfer of an IRA or Archer MSA balance to a health savings account is also permitted, up to the contribution limits. This is obviously an advantage for those who have medical bills that an IRA distribution must be taken to pay for. (For related reading, see Tax Treatment Of Roth IRA Distributions.)
  5. Perhaps best of all, any unused money that is not paid out for medical expenses can eventually be used as retirement income, just like an IRA. This substantially reduces much of the risk inherent in paying for traditional health insurance, where the premiums paid are lost if no claim is made.

Additional Benefits of HSAs
For those that qualify, HSAs can resolve a huge dilemma between saving for retirement and paying current or future medical bills. This is particularly true when long-term care may be needed. While the cost of a nursing home or other skilled care can be staggering for many, the opportunity cost of paying for long-term care insurance is also very high. Health savings accounts can valuable in these cases, as shown in the following example:

Joe and Betty Smith own a successful jewelry business. Joe and Betty are 65. Neither of them has access to group health insurance of any kind. Joe has had a respiratory problem for years, and Betty\'s family has a history of heart disease. They are currently contributing to a self-employed 401(k), but they are concerned about the possible medical or long-term care bills that they may have to pay in the future. They are not sure if they have sufficient assets or income to fund both their retirement and their possible health costs.
The solution, of course, is to open a health savings account. They can contribute $5,650 to the account each year, plus an additional catch-up contribution for Joe. The premiums that they pay for their HDHPs are deductible as well. Furthermore, if they decide to pay for long-term care insurance, most or all of the premiums can be paid for with distributions from the account. Because contributions are deductible and distributions are tax-free, the Smiths are able to deduct the most or all of the cost of their long-term care insurance policy, which otherwise would not have been possible.
Finally, all money contributed will grow tax free until used for medical bills, or tax deferred until used as retirement income. One way or another, the Smiths are certain to be able to use the money (barring what is paid for the HDHP premiums) constructively for something! This will simplify and improve the Smiths\' ability to plan for their retirement. They could decide to roll over a portion of their 401(k) up to the contribution limit into the account if they feel certain that they will have to use the plan\'s assets to pay medical bills. This transfer will, of course, reduce their tax bill accordingly.

Health savings accounts ultimately represent the next major step forward in tax relief for those without access to group health coverage. Those who qualify have absolutely nothing to lose by opening one, as all contributions are guaranteed to be used one way or another.

Related Articles
  1. Retirement

    What to Do When Your Doctor Doesn't Take Medicare

    Stay and pay the full fee? Cut and run to another provider? Five ways to cope when Medicare threatens to break up you and your medico.
  2. Retirement

    4 Reasons Why Americans Retire in Costa Rica

    Understand why more and more Americans are deciding to retire in developing countries. Learn about the top five reasons why Americans retire to Costa Rica.
  3. Retirement

    4 Reasons Why Americans Retire in Mexico

    Learn why Mexico's low cost of living, inexpensive health care, natural beauty and culture make it such a popular retirement destination for Americans.
  4. Stock Analysis

    How Does Oscar Work and Make Money?

    Learn how startup Oscar is taking on the health insurance giants by offering customers free doctor's visits, generic drugs and 24-hour phone access to doctors.
  5. Retirement

    The Cities Where the Ultra-Rich Retire in Florida

    Understand why the Florida communities of Miami Beach, Palm Beach and Key West serve as magnets for the ultra-rich retirees who descend on the state.
  6. Investing Basics

    Statistical Proof That Buy-and-Hold Investing Pays Off

    Learn about how the data suggests that the buy-and-hold investment strategy still works, even after the huge declines of the Great Recession.
  7. Retirement

    The 5 Best Retirement Communities in Austin, Texas

    Discover five of the most desirable retirement communities for seniors located in the Austin/Georgetown metropolitan area in Texas.
  8. Options & Futures

    Pick 401(k) Assets Like A Pro

    Professionals choose the options available to you in your plan, making your decisions easier.
  9. Investing Basics

    5 Things To Ask Before Hiring A Financial Advisor

    Choosing a financial advisor isn't an easy task. Here's a list of the most important things to consider when planning for your financial future.
  10. Retirement

    Retired & Rich? The 5 Most Luxe Timeshares

    Timeshares have gone seriously upscale. No longer mid-range vacation places, here are some very deluxe locations for retirees.
  1. Can I borrow from my annuity to put a down payment on a house?

    You can borrow from your annuity to put a down payment on a house, but be prepared to pay an assortment of fees and penalties. ... Read Full Answer >>
  2. What are the main kinds of annuities?

    There are two broad categories of annuity: fixed and variable. These categories refer to the manner in which the investment ... Read Full Answer >>
  3. What are the risks of rolling my 401(k) into an annuity?

    Though the appeal of having guaranteed income after retirement is undeniable, there are actually a number of risks to consider ... Read Full Answer >>
  4. How do I get out of my annuity and transfer to a new one?

    If you decide your current annuity is not for you, there is nothing stopping you from transferring your investment to a new ... Read Full Answer >>
  5. Are Cafeteria plans exempt from Social Security?

    Typically, qualified benefits offered through cafeteria plans are exempt from Social Security taxes. However, certain types ... Read Full Answer >>
  6. What are the biggest disadvantages of annuities?

    Annuities can sound enticing when pitched by a salesperson who, not coincidentally, makes huge commissions selling them. ... Read Full Answer >>

You May Also Like

Trading Center
You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!