How Your Health Savings Account Can Be a Tax Shelter

Many readers may be generally familiar with the health savings account (HSA). It allows individuals and families to set aside money for medical expenses. There is a strong likelihood that the incoming administration will expand the role of this useful tax shelter in the new year. This article discusses some ways the HSA will evolve as well as some savings strategies for those with disposable income. (For related reading, see: How to Use Your HSA for Retirement.)

HSA Background

Signed into law in December 2003, HSAs are available to employees (and the self-employed) with high-deductible health insurance coverage. Contributions can be made to the account by both the employer and employee, subject to annual limits. Funds may be disbursed to pay for medical expenses not covered by the underlying insurance. Unspent funds may be invested and accumulate over time. Accounts belong to the employee and move with him if he or she separates from service.

Today, annual contribution levels are capped at $3,350 for the individually insured and $6,750 for family coverage. After a slow start, HSA popularity has grown. Nearly one-third of all employers (31%) now offer some form of HSA, up from 4% in 2005. There are now more than 18 million accounts and more than $34 billion in HSA assets

HSAs have strong tax shelter properties. Contributions to the accounts are tax deductible and may be used to pay for qualified medical expenses without triggering taxable income. Thus, they combine the best features of the traditional IRA (tax deduction on the way in) and the Roth IRA (tax free on the way out).

Reforms That May Come

Until recently, HSAs have had a low profile. In fact, many employees confuse them with flexible savings accounts (FSAs), which are compatible with all types of health plans but require employees to spend down most of the account by year end. HSAs now may be emerging from the shadows. The new leadership in Washington is likely to expand consumer-driven health care in an effort to mitigate the large price increases looming over the health insurance market in 2017. There is no shortage of ideas, and many of them include an expanded role for HSAs.

Conservative thinkers have called for increased contribution limits to HSAs. David Hogberg of the National Center of Public Policy Research proposed expanded contribution limits last year in a policy paper that also addressed Medicaid reform. HSA contribution limits would range from $2,700 to $9,000 annually depending on a person's age. Other writers, such as Scott Atlas of the Hoover Institute, have proposed contribution limits similar to those for IRAs—$5,500 per person and $6,500 for those over age 50.

We can also assume an expansion in the scope and utility of HSAs. Right now, eligibility for an HSA is restricted to those with high deductible policies who are not enrolled in Medicare. People may soon be allowed to contribute HSAs regardless of their age or health insurance policy form. Today, HSA dollars cannot be used to pay for medical insurance premiums (there are a few exceptions). Reform legislation may lift this restriction as well. Bottom line is that we'll likely see many more HSAs in the U.S. in 2017. They will have more assets and will be more flexible. (For related reading, see: Comparing Health Savings and Flexible Spending Accounts.)

Key Takeaways for the Mass Affluent

For those with substantial disposable income, the HSA can serve as a long-term savings tool rather than an account from which to fund ongoing health needs. In fact, the mass affluent are better served by not spending their HSA funds while they are working. Instead, they should let HSA assets accumulate tax-free over time by investing contributions in diversified stock and bond funds. These accounts can become a strategic part of a retirement portfolio. Their after tax value is not diluted by income tax liability. Like any other portfolio, the asset allocation of the HSA should be coordinated with one’s other investment accounts.

So far, investment of HSA balances is not happening on a large scale. Only $4.7 billion of the $34 billion in total HSA assets is invested in securities. The rest remains in cash presumably earmarked for ongoing medical expenses. However, invested assets have been growing faster than overall account levels. If the new administration loosens the limits on the use and size of these accounts, we’ll likely see more action on the part of consumers. For those that can afford it, the HSA is a powerful tax shelter. (For related reading, see: Pros and Cons of a Health Savings Account.)