The Loop

HDHP + HSA: A Versatile Savings Combination

Filed under: Benefits

Healthcare expenses have gotten out of hand. Many experts blame the development health insurance plans with such generous benefits that consumers became insulated from the true cost of medical attention – rushing to the doctor's office or emergency room for every sniffle, cramp or headache.

Others lament the advent of pharmaceutical companies advertising their wonder drugs directly to consumers, who subsequently insist on physicians prescribing them. And then there's the case for utter lack of personal responsibility. The nature of modern society has led folks to eat less nutritious fast/prepackaged food, eschew exercise, and turn to the comforts of alcohol and overeating as a means of dealing with increasingly stressful lives. Their health has suffered the consequences, leading to higher incidences of chronic disease, obesity, and mental health issues.

Fortunately, in recent years the growth in healthcare expenses has slowed down. In 2013, the growth rate for national healthcare spending was 3.6 percent, which constituted the lowest rate of increase since 1960. Regardless, that's still more than double the 1.5 percent overall inflation rate for 2013.

High Deductible Healthcare Plans
Deductible healthcare plans have been around for a very long time. In fact, they used to be de rigueur as indemnity plans that would pay 80 percent of claims once a nominal deductible – $200 or so – was met. However, with rising costs came rising deductibles. Today, The IRS considers any plan that has an annual deductible of $1,300 or more for individuals or $2,600 for families a High-Deductible Healthcare Plan (HDHP). In 2015, the average deductible for the lowest tier Bronze-level plans is about $5,181 for individuals and $10,500 for families. However, deductibles can run as high as $6,450 for an individual plan and $12,900 for a family plan.

Usually, HDHPs charge a lower monthly premium as a trade-off for the higher deductible. The higher the deductible selected, the lower the premium.

HDHPs are offered with a variety of service provider options, including the Preferred Provider Organization (PPO), Health Maintenance Organization (HMO), and Point of Service (POS). Depending on the HDHP, members may have the choice of using in-network or out-of-network providers, with in-network providers saving them the most money. With the exception of preventive care, the annual deductible must be met before plan benefits are paid.

Health Savings Accounts
Some HDHP plans are eligible to be accompanied by a Health Savings Account (HSA). These individually owned savings accounts are designed to take some of the sting out of the high deductible, as account savings may be used for out-of-pocket healthcare expenses the owner incurs. Ideally, these savings pay for expenses up until he meets the high deductible, at which point the HDHP coverage kicks in.

While an HSA may be opened only in combination with an HDHP, distributions may continue to pay for qualifying expenses even if the participant switches to another type of health insurance policy. However, contributions are no longer allowed once the owner terminates his HDHP.

Because members use HSA money for initial out-of-pocket fees, they see firsthand how much bills and prescriptions cost, and therefore have become smarter shoppers of healthcare services. As a result, one study by Cigna found that the medical cost trend was 20 percent lower for HDHP/HSA customers than those with traditional plans.

HSA Contributions
An HSA enables the owner to pay for eligible medical expenses with tax-free dollars. He may deduct the amount he contributes to his HSA on his tax return without having to itemize. Or, depending on his employer's plan, contributions may be taken directly from his paycheck before taxes are levied. An employer also may contribute to employee HSAs as a benefit, and those contributions are not taxable to the employee or subject to FICA (Social Security retirement and Medicare) employment taxes. Nor is a recipient's earned income credit (EIC) affected by employer contributions.

Total contributions made by both employer and account owner may not exceed the annual limit: $3,350 for individual coverage or $6,650 for family coverage. In addition, members age 55 and up may make "catch-up" contributions of up to $1,000 each year. Note that contributions to an HSA can accumulate year after year without limit or possibility of forfeiture. This is unlike the "use it or lose it" requirement of an employer-sponsored flexible savings account (FSA).

The last-month rule allows individuals who enroll in an HDHP late in the year but are eligible to make HSA contributions as of December 1 to contribute the full annual limit, including the catch-up contribution. The owner must then retain the HDHP coverage for a full year or those HSA contributions will be subject to taxes and penalties as an excess contribution. Participants may make tax-deductible contributions up until April 15 of the following year.

HSA Tax Advantages
The HDHP+HSA strategy offers multiple tax advantages: A tax deduction up-front, tax-deferred growth of contributions, and tax-free withdrawals for qualified healthcare expenses. Any distributions made before age 65 that are not used for qualified expenses are subject to income taxes plus a 20 percent penalty. After age 65, only income taxes are due on non-qualified withdrawals – no penalty. If an employer also makes contributions, they are free of FICA taxes. When used correctly, the account basically pays for healthcare expenses tax-free.

Retirement Savings Advantage
One retirement savings strategy is to take advantage of the tax-deferred growth within an HSA as an ancillary retirement savings account. If a participate can afford to pay his healthcare expenses out-of-pocket, his additional HSA contributions can then compound for decades and be used for healthcare (or any other expense) in retirement. This can be particularly appealing to people who do not have a lot of healthcare expenses as an additional tax-deferred retirement savings vehicle.

In fact, an HSA can be more attractive than a traditional IRA for two reasons. First, there is no income limit for deducting contributions. In other words, contributions are deductible even if the account owner earns a million dollars a year. Second, the contribution limit for members with a family HDHP is higher than the annual contribution limit for a traditional or Roth IRA.

Depending on the account, members may use a checkbook or debit card to pay for medical expenses either at the provider's office or when they receive a bill. However, they also have the option to pay out-of-pocket and then withdraw funds to reimburse themselves later. This is particularly beneficial if they haven't accumulated enough money in the HSA to cover current medical bills. As long as the member is enrolled in the HSA before she incurs the medical expense and retains the receipts for eligible expenses, she can withdraw the money tax-free from the account at any time – even years later. Used in this manner, the HSA makes for a nice emergency savings account, making withdrawals (up to the total amount of retained medical bills) only when necessary.

HSA Limitations
Note that some high deductible plan participants may not be eligible to open an HSA. These include people who are:

• Enrolled in Medicare
• Covered by another healthcare plan that is not an HDHP
• Claimed as a dependent on someone else's tax return
• Enrolled in a general healthcare flexible spending account (or covered by a spouse's FSA)
• Are covered by a non-HDHP such as TRICARE and TRICARE For Life
• Covered by Veteran's Administration (VA) or Indian Health Service (HIS) benefits and have used VA or IHS medical services within the previous three months

However, plan participants are allowed to open an HSA even if they have other types of insurance policies such as accident, disability, dental care, vision care, long-term care, specified disease or illness insurance, or a limited-purpose FSA.

Strategies for Older Employees
There are many advantages to working past age 70, one of which is delaying Social Security in order to receive the highest benefit. Senior employees covered by an employer-sponsored HDHP can save more toward retirement by utilizing a limited-purpose FSA, an HSA, and required minimum distributions (RMD) from a traditional IRA.

For example, a worker above age 70½ can save money tax free in a limited-use FSA to reimburse out-of-pocket vision and dental expenses. He can also continue making tax-free contributions to an HSA if he delays signing up for Medicare. Even though his traditional IRA requires he begin minimum distributions at age 70½, he can use that money to continue making HSA contributions and claim the ensuing tax deduction.

The HSA also allows for an interesting loophole for traditional IRA owners. When funds are withdrawn from these tax-deferred retirement accounts, they are taxed at the owner's ordinary income rate in the year withdrawn. However, one way to avoid taxes on IRA assets – or at least a portion of them – is to conduct a tax-free transfer into an HSA account. An IRA owner may make a one-time contribution in the form of a direct transfer to his HSA account from his IRA account, up to the maximum annual HSA contribution limit. The advantage is that he will not have to pay taxes or penalties on the IRA distribution as he would if he'd paid for medical expenses with the money from his IRA. In fact, as long as he uses the money from his HSA for qualified medical expenses, he won't ever have to pay taxes on the money transferred from his traditional IRA.

However, be aware of a couple of caveats with this strategy. First of all, this IRA rollover/contribution amount may not be deducted from his income tax return. Second, the transfer is subject to a 12-month testing period during which time he must remain HSA-eligible.

Not only can this strategy help build a separate savings account specifically for healthcare expenses, but it also can reduce a member's tax liability on other retirement savings. Furthermore, HSA funds may be used to reimburse the money withheld from Social Security benefits to pay for Medicare Part B, pay Part D or Medicare Advantage premiums, and pay for a portion of long-term-care insurance premiums.

Remember, once an account owner turns age 65 he may use HSA funds for any purpose, not just medical expenses – which is why the HSA can be an excellent tax-free vehicle for retirement savings. Amounts withdrawn after 65 for non-qualified medical expenses will be subject to income taxes but no other penalties.

HSA Investment Opportunity
The popularity of the HDHP+HSA combination has driven up demand over the last year. HSAs typically set a minimum account balance that must be reached before the owner can then invest those assets in investment options. As of December 2014, invested assets in HSA accounts reached an estimated $3.2 billion, up 40 percent over the prior year. HSA investment account holders hold an average balance of $12,995 (including deposits and earnings). Moreover, HSA accounts have experienced solid returns, with an average annualized return of 12.5 percent over the last three years.

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