A health savings account (HSA) is similar to a 401k. But instead of saving for retirement, you are instead putting money away for future medical expenses. And yes, there are some lucrative tax benefits.
So what are the requirements for getting an HSA? Well, let’s take a look:
- You cannot contribute to an HSA if you are on Medicare (Part A and Part B) or Medicaid. In fact, you cannot be enrolled in any non-HSA qualified health insurance plan.
- You must have a high deductible health plan (HDHP). “Specifically, your HDHP must have a minimum deductible of $1,400 for individuals or $2,800 for families,” said Andrew Chen, who is the founder of Hack Your Wealth. “The max out-of-pocket allowed by law for an HDHP is $6,900 for individuals or $13,800 for families. These figures are for 2020.”
- You cannot be claimed as a dependent on someone else’s tax return.
- You cannot have a general-purpose flexible spending account. However, you can have a limited one, such as for dental, vision or dependent care.
- There are maximum amounts for annual contributions. For 2019, the limit was $3,500 for individuals and $7,000 for family coverage. As for this year, the individual cap is $3,550 and $7,100 for a family. What’s more, if you are 55 or older, you can contribute an extra $1,000.
If you spend money from your HSA, it must be for qualified medical expenditures. “These are generally any expenses that would have been eligible for the medical or dental expenses deduction, plus expenses for prescription drugs,” said Chen. “They include insurance premiums if you’re on a COBRA plan or if you’re receiving unemployment benefits. They also include Medicare (not Medigap) premiums and long-term care insurance (subject to deduction limits).”
With your contribution and earnings from an HSA, there is no “use it or lose it” policy. “You own your HSA account and can take it with you if you leave your current employer and roll it over into a new account, just like a 401(k),” said Shobin Uralil, who is the co-founder and COO of Lively, which is a provider of HSAs. “Most importantly, you are creating long-term savings to pay for any health expenses throughout your life.”
The Tax Benefits
There are three key tax benefits with an HSA. First of all, if you have an employer plan, then the contribution is with pre-tax income. Otherwise you can get a deduction on your annual tax return as an adjustment to income.
Next, the earnings in the HSA account — such as from capital gains, interest or dividends from funds — will grow tax free. And then, when you spend the money for qualified medical expenses, there is no tax owed. Generally, you make the payments with a debit card.
“While HSAs are tax-exempt from federal tax, it gets a bit more complicated on the state level,” said Uralil. “They are tax-exempt from most state income tax filings, but not all.”
And what if you spend money on non-medical expenses? If you are younger than 65, then you will be subject to a penalty of 20%. You will also have to pay taxes on the amount withdrawn.
Bottom Line on HSAs
One of the drawbacks of an HSA is that your underlying health insurance coverage may not meet your needs. In other words, it’s important to take a holistic look at your situation.
“The trick is finding the right balance between your contributions, your withdrawals and your ability to let your savings accrue over time,” said Rob Williams, who is the vice president of financial planning at Charles Schwab. “Before maxing out your HSA, you should prioritize contributing at least enough to your 401(k) plan to secure matching funds from your employer. Then, contribute what you expect to spend in out-of-pocket medical costs over the course of the year to your HSA. If you’re expecting more medical expenses in the future, you can increase contributions to your HSA and invest any unused funds.”
With an HSA, you also need to be diligent with your accounting, such as by keeping your receipts. This will be essential if the IRS audits your tax return.
You will also need to file a Form 8889 and attach it to your 1040. This will require working with other documents like Form 5498-SA, Form 1099-SA, Form W-2 and Form 5329. Yes, this can get cumbersome. So, it may be a good idea to seek out a qualified tax professional for this.
Tom Taulli is an Enrolled Agent and also operates PathwayTax.com, which is a tax advisory and preparation firm. Follow him on Twitter at @ttaulli. As of this writing, he did not hold a position in any of the aforementioned securities.
