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Understanding Health Savings Accounts

Filed under: Benefits

According to the Employee Benefit Research Institute, at least 20 million Americans own a health savings account (HSA). An HSA is a savings account that enables the owner to set aside money on a pre-tax basis to pay for healthcare services. If the money is used exclusively for qualified medical expenses, the owner never has to pay taxes on those contributions. If HSA funds are used for any other purpose, they are subject to a 20 percent tax penalty (up until age 65) as well as ordinary income taxes.

In many cases, both employees who receive company-sponsored insurance and self-employed workers are able to pay insurance premiums with tax-free money. When combined with a health savings account to pay for out-of-pocket expenses, all or much of their healthcare can be paid for with tax-free income.

An additional benefit is that, because the money used to pay premiums is taken out before income taxes are levied, the overall income tax bill is reduced.

Set Up and Contributions
HSAs are available only to people enrolled in a High Deductible Health Plan (HDHP), whether offered by an employer or purchased on the individual market. A HDHP is defined as having an annual deductible of at least $1,350 for individual coverage; $2,700 for a family plan (2018). An HDHP enrollee can open a health savings account through his bank or other financial institution. Anyone can contribute to a person's HSA, including the owner, his employer, or even friends and family. Be aware, however, that employer contributions must comply with non-discrimination rules in most cases.

The basis for pairing a health savings account with a high-deductible plan is that HDHPs generally charge lower premiums than a low-deductible plan. Thus, the plan owner can use the savings from a lower premium to help fund the health savings account to pay for out-of-pocket expenses – such as the plan deductible, co-pays and co-insurance.

For 2018, HSA owners may contribute up to $3,450 (up from $3,400 in 2017) for single coverage, or up to $6,900 (up from $6,750 in 2017) for family coverage. In addition, a $1,000 "catch up" contribution is permitted for account owners age 55 and up.

If contributions exceed the annual limit, the excess is subject to a six percent penalty. However, the overage may be withdrawn from the account by the tax filing date without penalty. Note that the excess withdrawn should then be reported as taxable income on that year's return.

There also is a rule that refers to "front loading" contributions. In other words, the contributions limit is technically pro-rated by month (divide annual limit by 12). Should you contribute the maximum amount at the beginning of the year but are no longer eligible later in the year, the overage is then subject to the penalty. However, should one spouse become ineligible, a spouse who remains eligible can still contribute up to the annual limit for a family plan.

Unlike other employer-sponsored healthcare savings plans, funds in an HSA roll over and continue to be available to the account owner year-after-year. Another unique feature of an HSA is that an employee retains ownership of the account and all funds therein even if he retires, changes jobs, or even changes to a non-HDHP. While he may no longer contribute to the HSA once he is no longer covered by an eligible HDHP, the owner may continue to use the accounts funds to pay for qualified medical expenses.

Another perk of the HSA plan is that the funds in the account can grow tax-free. Once the account balance reaches a certain threshold, the money can be invested in mutual funds, stocks and other investment tools to generate earnings that also are available to pay for healthcare expenses.

For this reason, many people use an HSA as a retirement savings vehicle. Unlike an IRA, HSA contributions are not required to come from earned income. This makes the HSA a popular alternative for people who live on investment income and seek a tax-advantaged investment. Account owners can further build their HSA balance by using current income to pay for healthcare expenses and allowing those funds to grow unfettered. Should an owner need money later he can technically withdraw HSA funds to "reimburse" himself; there is no deadline for submitting old receipts for out-of-pocket qualified expenses.

HSA funds may be distributed via check, debit card or reimbursement process, and the account owner does not need prior approval to make a withdrawal. However, it is necessary to keep invoices and receipts documenting how funds were spent. They are not required to be filed with taxes but must be available should the owner be audited.

Medicare Rules
A health savings account owner is prohibited from making contributions to the account past age 65, which is the age of Medicare eligibility. By law, anyone age 65 or older receiving Social Security benefits also must be signed up for Part A of Medicare. Since Medicare coverage does not qualify as a high-deductible health plan, this also means a 65-year old may no longer contribute to his HSA.

However, there is an exception to this rule. After turning age 65, if the owner has not yet filed an application for either Social Security retirement benefits or Medicare, he may continue contributing to the HSA – as long as (1) his employer has 20 or more employees, and (2) he is still covered by an HDHP. Once his employment ends he will be entitled to a special enrollment period to sign up for Medicare, at which point he can no longer contribute to the health savings account. He can, however, continue to use money from the existing account to pay for qualified healthcare expenses such as Medicare and long-term-care premiums, dental work, caregiving expenses, etc. He also may withdraw funds for non-healthcare expenses without penalty, but that money will be subject to income taxes in the year withdrawn.

Inherited HSA
There are certain rules related to leaving a funded health savings account to loved ones after the owner passes away. If the account is bequeathed to the owner's spouse, she simply becomes the new owner and is subject to all of the same rules and tax benefits during her lifetime.

If the account is left to a non-spouse heir, it becomes taxable income to the heir in the year of the owner's death. This is worth noting since tax benefits are best utilized by paying for medical expenses while the owner is alive rather than leaving the assets as a taxable inheritance.

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