Most individuals plan for the future, saving money to live off of during their eventual retirement.  How many people plan in advance how to specifically pay for their medical expenses during retirement?  Tax-advantaged Health Savings Accounts (HSA) give individuals that option.  They have the flexibility to be used now or in the future to pay for qualified healthcare expenses.

An individual must be covered by a high deductible health plan (HDHP) in order to establish an HSA account.  There is no income limitation, unlike many other tax savings accounts.  The contribution limits for 2013 are $3,250 for single coverage and $6,450 for family coverage.  For those 55 years and older, there is a $1,000 “catch-up” provision until you enroll with Medicare.

Both contributions to and distributions from an HSA account are filed with your 1040, reported on Form 8889.  Any distributions for qualified medical expenses are not taxed.  The amounts of qualified medical expenses are reported separately on Form 8889.  Under the Patient Protection and Affordable Care Act a prescription is needed for over-the-counter drugs to be reimbursed.  For any distributions used for unqualified medical purposes, the distribution is subject to both tax and a 20% penalty.  The 20% penalty applies only to age 65.

An HSA may be better than other health plans or other tax-advantaged accounts individuals may be more familiar with.  Usually an HSA plan has lower premiums than traditional health insurance plans.  There is usually the flexibility to adjust the amount of HSA contributions on a monthly basis. Often there is better utilization of funds with reduced claims, with individuals under HSA’s becoming more aware of the cost of medical procedures.  Many expenses not covered in traditional insurance plans such as vision, dental, and orthodontic are qualified medical expenses for HSA’s.  Long-term care insurance premiums and even Medicare Part B premiums can be paid with HSA funds.

Unlike flexible spending accounts where annual unused funds contributed are lost, an HSA account allows unused contributions to roll over to future years.  This is a great opportunity to stash additional funds during years when less medical services are needed to be used at a later time.  Also, individuals are able to take their HSA accounts with them if they leave an employer because the accounts are individually owned.

Traditional PPO plans with copayments may be more unpredictable than HSA’s.  Often, copayments do not count towards the out of pocket maximum on most traditional PPO plans.  So after the deductible and coinsurance stop-loss amounts have been reached, the copayments will still continue under traditional PPO plans.  In essence the traditional PPO is really uncapped.

The greatest benefit is that an HSA can be a completely tax-free account.  The funds contributed by your employer or made by an employee through a company provided cafeteria plan (Section 125 plan) are taken out pre-tax.  These funds contributed earn tax-free investment income allowing them to grow tax deferred each year.  Individuals never pay tax on the distributions as long as they are used for qualified medical expenses.  For individuals who are able to fund an HSA and only take limited distributions from it to pay current medical expenses will see the greatest benefit. 

HSA’s are similar to Individual Retirement Accounts (IRA’s) in some regards.  Contributions to HSA’s and IRA’s may both be deductible on the individual’s 1040 if paid with after-tax money.  The difference is the HSA contributions are not subject to income limits while IRA contributions are.  Also, after age 65, individuals are allowed to withdraw funds from HSA’s for non-qualified expenses that will be taxed, but not subject to any penalty.  Generally for traditional IRA’s, the minimum age for fund withdrawal is 59 ½ to be taxed with no penalties.

There is even the benefit of flexibility of how funds can be withdrawn from HSA accounts.  Most HSA’s have multiple withdrawal methods.  Some HSA’s provide checks to be written by the account holder, some provide a debit card, and still others may allow for a familiar reimbursement process similar to medical insurance.

With today’s rising health care costs, HSA plans may be an option.  Please contact your tax professional at Dermody, Burke & Brown if you have any questions.

The information reflected in this article was current at the time of publication. This information will not be modified or updated for any subsequent tax law changes, if any.