What is an HSA?
- HSA - Health Savings Account
- HDHP - High Deductible Health Plan
Health Savings Accounts are a specific type of account that provide tax advantages for setting money aside specifically for healthcare needs. In order to qualify for an HSA, you need to have a high deductible health plan (HDHP) and not be covered by another health plan. To determine if your health plan qualifies, ask a professional financial adviser, your HR department, or your health insurance provider.
Why choose a high deductible health plan?
Most people hate paying insurance deductibles and co-payments, so you may wonder why you would want a high deductible plan. The fear is obvious, if you have a major medical problem, then you would be paying for more of the costs under the HDHP. With proper planning, however, the combination of the HDHP and the HSA can result in both short-term savings and long-term financial benefits.
Lower Insurance Premiums
The first benefit you'll see with a HDHP is lower insurance premiums. With HDHPs, you have transferred less of the risk to the insurance company, lowering your overall insurance costs. The higher deductible means you will have to pay for a larger portion of the healthcare costs, but the benefit is that you'll pay less for the insurance.
Deductibles Paid with Saved Money
During years where you don't have any major medical problems, the savings on the insurance costs will likely be greater than your share of the healthcare costs. The money you save on insurance premiums then can be used to fund both current and future deductibles. When you have a major medical expense, you should have plenty of money to pay for it assuming you've fully funded the HSA.
You Get Access to an HSA
The biggest benefit of a HDHP is that it gives you access to an HSA with its tax advantages. If you have a choice, choosing the HDHP to get access to the HSA can have long-term financial benefits. Although delaying switching to an HDHP and starting the HSA may make sense if you are expecting a major medical expense (like a pregnancy), over the long-run you may still see a financial benefit.
Why HSAs are Incredible?
You may be wondering what makes an HSA account so special. There are a wide variety of benefits that HSAs provide, and unlike other tax advantaged accounts, you don't have to choose between the benefits.
HSAs Lower Your Income Taxes
Qualifying contributions to your HSA account reduce your taxable income, meaning that they will provide you with a tax savings equal to your highest marginal tax rate. Although they are not deductions, HSA contributions act in the same way. Anytime you can do something that keeps Uncle Sam from reaching into your paycheck is something to look into.
HSA Distributions are Tax Free
Most tax advantaged accounts force you to choose between getting the tax advantage now in the form of a tax deduction, or taking the tax advantage later in the form or tax-free distributions. Not the HSA! If you use the HSA funds for qualifying medical expenses, you'll get the tax break now and again later when you take tax-free distributions. The double tax savings really sweetens the pot of why an HSA is so valuable.
Unused Funds can Grow Exponentially
Money in an HSA may be invested in a wide variety of investments; including stocks, bonds, real estate, mutual funds or other assets. If you fund your HSA with $5,000 this year, but only have $2,000 in medical expenses, then the remaining $3,000 can be invested and continue to grow tax-free until you need the money.
HSAs Increase Retirement Savings Caps
The average person will spend over a million dollars in retirement for healthcare expenses. This means that any money in your HSA at retirement can be used to pay for those medical expenses, leaving your actual retirement accounts for more enjoyable purposes. Money in an HSA account doesn't count toward your maximum cap on retirement contributions. If you have already maxed out retirement savings, fully funding an HSA can allow you to invest thousands of dollars a year more toward retirement. You'll have to use HSA money for medical expenses, but if you know someone over age 65, you know that won't be a problem.
How to Manage the HSA?
Once you've opened an HSA, you'll need to manage the account. Below are important factors to consider when managing your HSA.
Use HSA Money Only for Medical Expenses
As of 2014, medical, hospital, and surgical expenses for you, your spouse, and your dependents all qualify, but medications require a doctors prescription to qualify. If you use the money for non-medical expenses, you'll get hit with the taxes plus a painful 20% penalty. The 20% penalty is removed, however, once you reach age 65, become disable, or die.
Preserve the HSA Funds
During years where you don't have major medical expenses, you should pay for small medical costs out of your pocket rather than using your HSA money. The more money you save in an HSA account, the bigger the tax benefit will be. And of course, the money remaining in your HSA simply augments your retirement savings. There is even an argument that saving in an HSA account trumps saving for retirement due to the tax advantages and the flexibility to use the money for medical expenses before retirement age.
Keep at Least 1 Year in Cash
HSAs are there to help pay for your annual out of pocket medical expenses when you have a major healthcare issue. Since you have no idea when you will have a major medical emergency, you should keep a pool of money in the safest form possible, cash. Ask your insurer what your annual-out-of-pocket is on your insurance and keep at least that amount in cash. If you have major medical expenses, then you know that the HSA money will be there to cover it. Once you've run through the cash and hit your annual-out-of-pocket expenses, the insurance will take over paying for 100% of any and all medical expenses for that year.
Keep 2-3 Years in Bonds
In addition to your minimum pool of money in cash, you should have at least 2-3 years worth of annual-out-of-pocket expenses in bonds or a safe bond fund. Medical emergencies often spill over into multiple years. As a result, one year of annual-out-of-pocket expenses may not be enough. If the rest of your money is invested in the stock market, you could find yourself in a financially unfavorable position if you have that medical expense the same year the market crashes. Having a few years worth of expenses in less volatile bond funds will give you a few years to let the market recover. This spillover is also a reason why you might want to have more than a year's worth of annual-out-of-pocket in cash.
Invest the Rest Aggressively
Once you have 3-6 years of annual-out-of-pocket expenses in cash and bonds, you'll be well prepared for the potential double hit of a medical emergency coinciding with a market downturn. This cash and bond safety net will allow you to grow the rest of your HSA money in a more aggressive manner with the intention of using that money for retirement savings.
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