In 2014, there was $22.1 billion in assets held in health savings accounts (HSAs), and the numbers show that the use of these accounts is growing. A health savings account is an IRA-like account that supplements a high-deductible health plan (essentially a bronze plan from a government exchange or private insurer). The arrangement offers you a way to obtain low-cost medical coverage while protecting your out-of-pocket exposure for medical expenses. The arrangement has a number of unique advantages. 

Contributions are deductible

If you are not eligible for Medicare (you are under age 65) and you have a high-deductible health plan (HDHP) (but no other health plan), you can make contributions to an HSA. The contribution can be made each year that you have an HDHP. The annual contribution limit is fixed by the IRS and varies with the type of coverage: 

  • For self-only coverage: $3,350 in 2015 and 2016

  • For family coverage: $6,650 in 2015 and $6,750 in 2016

Those who are at least 55 years old can add another $1,000. Thus, if a couple, ages 58 and 56 respectively, have family coverage, their contribution limit for 2016 is $8,750 ($6,750 + $1,000 + $1,000). (For a couple to qualify for two additional contributions, each person must have an HSA account, either a self-only or a family plan.)

If you had an HDHP on the first day of December, you can make a full-year contribution (no proration is required). Thus, if you had no coverage for the first 11 months of the year, or coverage that you had was not an HDHP, you can still contribute the full amount to an HSA for the type of plan that is in place on December 1. However, you must continue the HDHP coverage for 12 months to avoid a penalty.

The deduction for the HSA contribution is taken from gross income so no itemizing is required. There are no income limits on contributors. Contributions for the year can be made up to the due date of the federal income tax return to which they relate. Thus, the deadline for making an HSA contribution for 2015 is April 18, 2016 (April 19, 2016, for those in Maine and Massachusetts).

Note: If your employer maintains an HDHP and makes contributions to an HSA on your behalf, you are not taxed on this benefit. This tax-free fringe benefit is also exempt from FICA taxes. An employer-created HSA is portable, so it is yours even if you leave the job. If your employer makes a partial contribution (less than the dollar limit for your type of coverage), you can make up the difference and deduct your contribution.

The advantage of income deferral

Funds contributed to an HSA are invested in various types of investments. Some organizations chosen to administer the plan, which may be a bank, credit union, insurance company, brokerage firm or mutual fund company, pick the investment for contributors. Some administrators, such as Vanguard and Wells Fargo, offer a menu of investment options to the account owner. Thus, the account owner can be as conservative or aggressive with investment choices as the menu permits.

Whatever investments are used, the earnings grow on a tax-deferred basis. Tax deferral allows earnings to compound without any reduction for current taxes.

Tax-free distributions, too

You can withdraw funds from an HSA at any time for any reason. You don’t have to ask permission; you merely take a distribution. If the distribution is used to pay qualified medical expenses (those costs that would be deductible if you took an itemized medical deduction), the entire amount withdrawn is tax-free.

If you take a distribution for any other reason, the distribution is taxable. What’s more, if you are under age 65, this non-qualified distribution is subject to a 20% penalty.

Retirement savings

Contributions to an HSA do not have a use-it-or-lose-it feature like flexible spending accounts (FSAs). (For more on the two types of plans, see Comparing Health Savings And Flexible Spending Accounts.) Instead, if you stay healthy and do not tap your account to pay out-of-pocket medical costs (or any other costs), the funds in the HSA continue to grow on a tax-deferred basis. Once you reach age 65 – the age at which you can no longer make contributions to an HSA – the funds can be used penalty-free for any purpose, although they will be taxed if not used to pay medical expenses.

There are no required minimum distributions from an HSA as there are from an IRA. Thus, the funds can remain in the account indefinitely. Upon death, the funds pass to a designated beneficiary, who is the person you name to inherit the account:

  • If the designated beneficiary is a surviving spouse, he/she can treat the account as his/her own (i.e., continue tax deferral and tax-free distributions for medical expenses).

  • If the designated beneficiary is any other person, that person must report the value of the account as income in the year of the owner’s death. However, if the beneficiary pays any medical expenses for the owner within one year of death, those disbursements reduce the taxable amount for the beneficiary.

  • If there is no designated beneficiary so that the funds pass to the owner’s estate, the balance is reported as income on the owner’s final income tax return.

The Bottom Line

Health savings accounts are the only tax break offering triple benefits: an upfront deduction, tax deferral for earnings and tax-free treatment for qualified distributions. And regardless of your income level, they may be the solution to your health care needs. You can find more details about tax rules for HSAs in IRS Publication 969.

For further reading, see Pros And Cons Of A Health Savings Account (HSA).

 

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