Open enrollment season for employee benefits is upon us. One thing worth checking out is a high deductible healthcare plan (HDHP) coupled with a Health Savings Account (HSA). HSAs offer a unique way to save for current and future medical expenses. The HSA is the only investment account in which contributions are tax-deductible and distributions are tax-free (as long as they are used for qualified medical expenses).
In order to contribute to a Health Savings Account (HSA), you must be in a high deductible healthcare plan (HDHP). The minimum deductible amount (2016) in these healthcare plans is $1,300 for an individual and $2,600 for a family. This is the amount you must pay towards healthcare expenses before your insurance will cover any expenses. The actual deductible in the HDHP plan offered by your employer may be higher than these minimums. While this might sound unattractive compared with the more traditional co-payment type of healthcare insurance, it could be attractive if you have relatively low healthcare expenses or if you are in a high tax bracket.
Let’s see how this works. In 2016, an individual in a HDHP can contribute $3,350 to an HSA. A family can contribute up to $6,750. In addition, if you are over 55, you can contribute an additional $1,000. For a family in the 33% marginal tax bracket, a contribution of $6,750 results in a tax deduction of $2,228. This would almost cover the full deductible of $2,600 if medical expenses were high for the year. If expenses were low, the tax savings could more than cover your out-of pocket expenses. Since HDHPs are typically less expensive for employers than traditional co-pay plans, many companies will contribute to an employee’s HSA to entice employees to sign up for the lower cost HDHP. This employer contribution is tax-free to the employee (although you cannot take a tax deduction for the employer contribution). Also, since HDHPs generally have lower premiums (for the employer and employee) than traditional co-pay type of health plans, you save money on your healthcare premiums.
Funds in an HSA grow tax-free as long as the funds are used for current or future healthcare costs. Eligible healthcare costs include amounts paid for doctor fees, hospital care, nursing home care, eyeglasses, hearing aids, and health insurance premiums. If funds are used for non-qualified expenses, the amounts withdrawn are taxable as ordinary income plus there is a 20% penalty if you are under 65.
One point of confusion is the difference between a Flexible Spending Account (FSA) and a Health Savings Account (HSA). An FSA allows pre-tax contributions to be set aside to cover eligible expenses, such as medical expenses, dependent care, and other expenses. One of the biggest differences between the HSA and FSA is that funds in the FSA must be spent in the year they are set aside (although changes have been made to allow a small amount of the funds to be carried over to the following year). Hence, an FSA can be thought of as “use it or lose it.” On the other hand, funds in an HSA do not need to be spent in the year they are contributed. In fact, due to the potential tax-free growth of the HSA account, it is advantageous to allow the HSA to grow and use other funds (if available) to cover current healthcare needs.
Healthcare costs continue to grow significantly faster than the general rate of inflation. As people live longer, it becomes increasingly important to plan for healthcare costs in retirement. According to a Fidelity study, an average retired couple age 65 in 2016 may need approximately $260,000 saved (after tax) to cover retirement healthcare costs. The Health Savings Account (HSA) provides a means to save and invest to cover these future healthcare costs. Plus, you get a tax deduction now!
Make sure you check out the HSA option during this year’s open enrollment. An HSA may not be ideal for everyone so do the math to see if it makes sense for you.
Feel free to contact us with any questions at info@L2Wealth.com.
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