What's an HSA and Should You Start One?

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Feel like you’re the only one without an HSA? Here’s your definitive guide to the world of Health Savings Accounts (HSAs) and how to decide if you should start one.

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There are so many acronyms associated with healthcare—HSAs, FSAs, PPOs, HDHPs—it can be tough to keep them all straight. Some are types of health plans and some are savings accounts and a few even sound like they’re the same thing (e.g. Medical Savings Accounts vs Health Savings Accounts). In this article, we’re going to talk about HSAs or Health Savings Accounts.

HSA Basics

HSAs are savings accounts to which you can contribute pre-tax money to pay for qualified medical expenses. In order to open one, you must also enroll in a High Deductible Health Plan (HDHP) and cannot have secondary health insurance (e.g. via a spouse’s health plan) that offers traditional coverage. The money you save rolls over from year to year which allows you to build a nest egg for medical expenses and as long as you follow the rules, you’ll never have to pay taxes on it.

HSA Rules

  1. Stay within the annual contribution limits. For 2019, these are $3,500 for an individual and $7,000 for a family. Any contributions that are in excess of these amounts are subject to income tax.
  2. Use the money for qualified medical expenses. As long as you’re under the age of 65 and haven’t become disabled, you must use the money you save for things like deductibles, copays, prescriptions and portions of your medical care that your insurance doesn’t cover. If you use your HSA savings for something else, like buying a car, for instance, then not only will you have to pay income tax on that money, you’ll also have to pay a 20% penalty.
  3. Maintain the HDHP coverage for at least a year. The IRS has what’s called a “testing period” of at least a year for HSAs. This period begins in December of the year in which you sign up and lasts through the end of the following year. So if you buy HDHP health coverage this year (2019), your testing period would start in December and extend through the end of 2020. This is to prevent people from buying an HDHP for a few months, just to contribute the annual limit to their HSA, and then canceling their high deductible coverage in favor of a more traditional plan. If you do cancel your HDHP within a year, you’ll have to pay income taxes on your contributions.
  4. If you have money in your account, you can use it. You can make an unlimited number of withdrawals and do not need to maintain a minimum balance.
  5. After 65 or if you become disabled, you can use the money on anything you want.

How HSA Contributions Work

If you buy your health coverage through your employer, they will take your HSA contributions automatically from your paycheck, just like they take any health insurance premiums for which you’re responsible. If you don’t have employer-sponsored health insurance, you can open an HSA on your own (as long as you have an HDHP) and make contributions whenever you like. You would then deduct the total amount of your contributions (up to the IRS limits) from your taxable income on your tax return.

The great thing about HSAs is that anyone can contribute to it. Your spouse, your employer, your friends and family—anyone can contribute to your account. The not so great thing is that each person who will be covered by an HSA needs their own. It’s like a health insurance plan in that you and your spouse can’t share an HSA nor can you add any other dependents like children or elderly parents.

Contribution limits change from year to year so before you decide how much you’ll contribute each month, check what the IRS limits are for that year. Like other retirement accounts, the IRS has a “catch-up” feature that allows you to make an increased contribution if you’re 55 or older. For 2019, the catch-up amount is $4,500 for an individual and $8,000 for a family.

Who Holds Your Money and How do You Use it?

Although you must sign up for an HSA in conjunction with an HDHP, your health insurance provider will not collect, house or distribute your contributions. Instead, you will open your HSA with a brokerage house or bank and that institution will act as the trustee of your account. If you have employer-sponsored health insurance, your employer will make this arrangement for you and all you’ll need to do is elect to set up and contribute to an HDHP and HSA.

In order to distribute your savings, your HSA trustee will either issue you a debit card which you can use to pay for your medical expenses directly, or they will require that you submit a proof of payment (like a receipt) and will then either send you a check or deposit the money directly into your checking or traditional savings account.

Yes, there are Tax Forms

If you open an HSA, there are three forms you need to be aware of.

  1. Form 5498-SA. This will come from your employer at the end of the year and will show all of the contributions to your account for that year.
  2. Form 1099-SA. This will also come from your employer at the end of the year and will show all of the distributions you’ve taken for that year.
  3. Form 8889. This is the IRS form you must complete and submit with your taxes. On it, you will report all of the distributions you’ve taken, indicating any that was used for something that wasn’t a qualified medical expense. You will also report any contributions in excess of the IRS limits. Note: the IRS doesn’t consider administrative or maintenance fees charged by your HSA trustee to be a distribution so there is no need to report these.

What Happens to Your HSA if You Die?

Like any other account you have, you must choose a beneficiary who will become the account owner should you die. If the beneficiary is your spouse, the HSA will be treated as if it’s your spouse’s HSA and he or she can use it the same as you would. If your beneficiary is someone other than your spouse, the account stops being an HSA and its fair market value becomes taxable to your beneficiary in the year that you die. That means if you leave your HSA to your child, he or she will have to claim its value on his or her tax return.

But don’t worry, if your family needs to pay for any of your medical expenses, they have up to a year after you pass to use the HSA money tax-free.

Pros of an HSA

It’s probably not hard to see the benefits of starting an HSA. You get to use pre-tax money to pay for medical expenses and because HDHP plans typically have cheaper premiums, an HDHP and HSA combination can lead to lower healthcare costs. Especially if you don’t need to use your contributions for a few years and can build up a good chunk of savings before you need an expensive procedure.

You can also earn tax-free money on your contributions through interest or, if you choose an HSA that allows you to invest your money, through improvements in the stock market. Because of this earning potential, and because you can use the money unrestricted after the age of 65, many people use HSAs as a retirement plan.

Cons of an HSA

A big drawback to HSAs is the requirement you buy an HDHP along with it. HDHPs, while having relatively cheap premiums, typically have high deductibles and out-of-pocket maximums. That means if you need an expensive medical procedure or care before you’re able to build up savings, you could end up spending more on your medical care than you would with a more traditional plan.

Another drawback is the requirement you use your savings for medical expenses. With other retirement accounts like 401ks, you can take out a loan penalty-free if you need to access the money for any reason but HSAs don’t have that option. If you’re under the age of 65 and not disabled, you will incur a 20% penalty in addition to increased income taxes should you use your contributions for anything other than medical expenses.

If you’re trying to decide whether or not an HDHP/HSA combination is right for you, review your medical needs and expenses from the last two years. Then consider any life changes coming up like the birth of a baby. Will the HDHP provide adequate health insurance coverage while you build your savings? Will you be able to stay with the HDHP for at least a year? There are lots of benefits to starting and maintaining an HSA account but only if you can maintain adequate health insurance coverage while you do it.

Wild Card: The IRS places no limit on the number of HSA accounts you have, just the annual amount you contribute. So theoretically, you could have 3,500 separate savings accounts, as long as you only contributed $1 to each.

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Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.