A Health Savings Account (HSA) can be an extremely beneficial tool for financial independence. An HSA allows an individual to pay for qualified health care expenses and save for future qualified medical expenses on a tax-free basis. The individual must be covered under a high-deductible health plan to be eligible, and the unused amounts in the HSA may be rolled over to the next year. As of 2017, an individual may contribute up to $3,400 per year and a family may contribute up to $6,750. Individuals age 55 and older may contribute an additional $1,000. Contributions are tax-deductible, and may be made up to the tax filing deadline in the next year. The IRS also allows one tax-free rollover from an IRA to a Health Savings Account up to the annual contribution limits, which could be advisable if cash flow is tight (this type of contribution does not qualify for a tax deduction).
An HSA can be funded with either pre-tax dollars or with after-tax dollars and a subsequent above-the-line tax deduction. There is no income limitation that affects a taxpayer’s eligibility to contribute to an HSA, and funds from an HSA may be withdrawn at any age as long as the funds are used for qualified medical expenses. Although the IRS dictates that health insurance premiums cannot be treated as qualified expenses, there are exceptions for long-term care insurance, COBRA coverage, coverage while receiving unemployment compensation, and Medicare. HSAs grow tax-free for the remainder of the taxpayer’s lifetime.
HSAs provide a significant opportunity to capture tax-free growth, especially if annual income exceeds the Roth IRA limitations set by the IRS. Health Savings Accounts qualify for the same tax-free growth of a Roth IRA, with an added tax deduction. Some may be hesitant to maximize contributions to an HSA because the funds are required to be utilized for qualified medical expenses. However, an important and often missed fact about Health Savings Accounts is that reimbursements are not required to be distributed in the same year expenses are incurred. Reimbursements may be made from an HSA at any time for past medical expenses as long as the expenses were incurred after the HSA was opened. (It is highly encouraged to save all receipts in the case of an audit.)
An HSA can be a very valuable tool at the time regular contributions are made while there is still time to take advantage of long-term tax-free growth, and before taxpayers become ineligible upon enrollment in Medicare. One potential disadvantage of holding a high balance in your HSA is that upon the owner’s death, although an HSA can be passed to a spouse tax-free, if the HSA is passed to a non-spouse beneficiary the fair market value of the account is included in the beneficiary’s income and the account loses its tax-free benefit. Because the account cannot be passed tax-free to a non-spouse beneficiary, it’s best to begin spending the account later in life and save the Roth IRA that passes tax-free upon death, or that non-qualified account that receives a ‘step-up’ in cost basis at death, for your children to inherit.
Written by: Samantha J. Anderson,CFP®