Learn why the HSA acts like a Roth IRA on steroids.
A few months back I discussed the importance of having a taxable investment account as part of your retirement plan. While the taxable account is underutilized by many physicians (one reason is that you may not be saving enough – tsk tsk!), it’s still well known. But there is another type of account – the health savings account (HSA) – that I think is used even less. Part of the reason is that you may not even know you can contribute to it. In this multi part series, I’m going to discuss how the HSA can be beneficial to you, the many rules you must know and how to avoid some pitfalls.
What is an HSA?
A health savings account (HSA) originated in 2003 as a way to allow you to manage current or future health care costs by contributing pretax dollars to the account and then paying for out of pocket medical expenses from the HSA account.
Who is eligible to open and contribute to the HSA?
There is a misconception that anyone can open an HSA account. That’s simply not true. I’ve seen physicians hear about HSA accounts as another way to save taxes and then they go out and open one, contribute to it, claim a tax deduction and realize they couldn’t do it.
You are eligible to contribute to the HSA if your health insurance is considered a high deductible health insurance (HDHP) plan. How do you find this out? The best way I know of is to simply call your health insurance and ask them if your health insurance is an HDHP plan and qualifies you to establish an HSA.
If your health insurance plan is not an HDHP plan then you cannot contribute to an HSA. However, if you switch to an HDHP health insurance plan later then you may be able to contribute so it’s worthwhile exploring what other health insurance plans are offered by your group or employer.
Furthermore, you cannot establish an HSA if you are covered under another health insurance plan that is not an HDHP – such as your spouse’s employer health insurance. If you or your spouse contribute to a flexible savings account (FSA) through yours or your spouse’s employer, then you cannot contribute to the HSA. You also cannot contribute to the HSA if you are enrolled in Medicare – this is especially important to know as you approach age 65 and enroll in Medicare at that time.
Where do you open the HSA?
There are lots of places you can open the HSA – from banks to a number of large custodians to specific HSA custodians. The key to understanding this is that when you open the HSA account, you are actually opening an account that is similar to a checking account. In other words, you contribute to the HSA account in pretax dollars and then you can spend that money from the HSA account like a checking account.
What are the tax benefits of HSA accounts?
The tax benefits are the biggest reasons to open and contribute to HSAs. They offer triple tax benefits if you follow the rules:
Current year tax deduction
To get the current year tax deduction you have two options:
(1) If your employer has set up the HSA account for you, then you can specify pretax contributions from your paycheck. You will see this on your paystub much like your pretax 401k contributions.
(2) You make your own contributions via your personal checking account. In this case you must report your contributions on your personal income tax return via Form 8889, Schedule 1 and Form 1040. What’s nice about the HSA is that unlike other deductions, it’s not phased out based on your income.
Tax deferral or tax-free growth on any gains in the account
This is similar to a pretax 401k in the sense that any dividends or capital gains distributions from the account are not taxed in the current year.
Tax free withdrawals
As long as you use HSA funds for qualified medical expenses, the withdrawals are not taxable. This is quite different from withdrawals from your 401k or SEP IRA. In those accounts, withdrawals are reported as income and you will be forced to withdraw a certain amount annually starting at age 70.5 regardless of what you decide to use the 401k/IRA funds on. When you withdraw 401k/IRA funds you will be taxed on those withdrawals.
So, in a sense the HSA account acts like a Roth IRA on steroids if you use the HSA account to pay for medical expenses. While both the Roth IRA and the HSA have tax deferred/tax free growth and tax-free withdrawals, the HSA gives you a tax deduction on the contributions, but the Roth IRA does not.
In the next part of this series, I’ll discuss more features of the HSA and how you can you use it to your advantage.
