Health Savings Accounts: The Ultimate Tax-Advantaged Accounts
Retirement Spotlight: Health Savings Accounts: The Ultimate Tax-Advantaged Accounts
Karyn McCormack: Welcome to Retirement Spotlight, Lord Abbett's podcast series. This is Karyn McCormack, content editor for Lord Abbett. Joining me is Lord Abbett's director of retirement solutions, Brian Dobbis. Brian writes a column on LordAbbett.com, speaks at advisor conferences, and is a wealth of information about all things retirement. Brian, today we're focusing on health savings accounts, which are growing in popularity. Can you explain how they work and why they are a good benefit for employees?
Brian Dobbis: Oh, thank you, Karyn, for having me here today. The health savings account topic is definitely-- a timely one. First and foremost-- a lot of folks have open enrollment this time of the year-- and we'll get into that a little further into today's session. But as medical expenses continue to increase, planning for them take on greater importance.
And health care expenses come in many forms, such as premiums, deductibles, copays, and coinsurance . Therefore, considering an HSA, or health savings account as they're more formally known, to utilize them to help offset future medical expenses. I say future medical expenses because a rule of thumb is as you age, your medical expenses will become more costly. You get ill more frequently, you go to the doctor more frequently, you have more costs.
And anecdotedly, medical expenses are underestimated by many taxpayers, many investors throughout the country when planning for specifically retirement income. The question, therefore is, "How much income do I need to offset future medical cost?" And a health savings account can definitely help with that.
You know, as for what is a health savings account and some of the benefits they offer-- there is a plethora of benefits. Health savings accounts are triple tax advantaged. You receive a federal income tax deduction when funding an HSA. Most states offer a state income tax deduction, and your distributions, including your earnings, Karyn, are distributed tax-free so long as you use the proceeds for qualified medical expenses.
Further, by funding an HSA directly from your payroll, you do not pay payroll tax. Therefore, on the employee side you're saving yourself 7.65% from the payroll tax, which is social security and Medicare. Third, a lot of employers will provide you seed money annually. Therefore, your employer may offer a benefit of funding your health savings account on your behalf. And Karyn, I think I've left the best for last, and probably one of the biggest misunderstood features of a health savings account.
Use it or lose it does not apply. So what does that mean? A lot of folks are probably more familiar with flexible spending accounts, and one of the drawbacks of a flexible spending account is you have to use the proceeds generally within that same calendar year. Not so much with health savings accounts. Therefore, an individual can allow an account to grow over a period of time, and you can reimburse yourself later in life-- for medical expenses tax-free.
Karyn McCormack: This is fantastic. Can you give our listeners an example of how an individual can get the most out of a health savings account?
Brian Dobbis: Yeah, great question, Karyn. So a very basic common example is-- I'll use myself. Let's say I go into the walk-in clinic today and it's $100 to see the doctor, and the doctor writes me a script and it's another $50 for the antibiotics. That's $150 of medical expenses. Ideally what I should do is pay that $150 from another source-- a checking account, a savings account. If I'm really good with my finances, maybe even put it on my credit card, so long as I pay it in the same month-- no interest accrues. Save the receipt, Karyn, and I can reimburse myself anytime for the rest of my life. So for example, 25 years from now, Karyn, I can go and take a distribution from my HSA for the $150, no tax impact.
Karyn McCormack: Wow, that's fantastic. Now, who is eligible to establish an HSA? Let's get to the beginning of setting one up.
Brian Dobbis: Sure. So unfortunately not everyone can fund and establish a health savings account. You do need to jump through a couple of hoops, and the most important hoop is you need to be covered under a high deductible health plan. And secondly, you cannot be enrolled in Medicare, and you cannot be claimed as a dependent on someone else's tax return. So again-- folks-- listeners, one of the things to do is to check-- to research to determine if your employer offers a high deductible medical plan.
Karyn McCormack: Now, can you define what that is, a high deductible health plan?
Brian Dobbis: Yeah. So Karyn-- a high deductible health plan, as the name indicates, these plans are designed such that the enrollees pay a larger deductible than your traditional health insurance. However, in exchange, your premiums are significantly lower. And theoretically, since you have lower premiums, you'll have more disposable income. Use this disposable income to fund a health savings account. Now, just a couple of things for our listeners to keep in mind. As a I mentioned, the premium-- the monthly premium-- is lower.
However, if you have medical expenses you have to pay more for health care costs before the insurance starts to pay their own share. So then the question that comes up frequently is, "Well, how do we define or determine a high deductible health plan?" Well, for 2019-- so for this year the IRS defines a high deductible health plan as any plan with a deductible of at least $1,350 for an individual, or $2,700 for a family coverage.
So if you incur an expense for a covered service, it counts towards the deductible. It just has to. However, Karyn-- and this is very important for our listeners-- you can't receive any benefit from a high deductible health plan until the deductible has been satisfied. Therefore, you can't have any benefits paid from the insurance company before the deductible, that $1,350. However, there is one exception to this rule, and that is for preventative care.
Generally get one visit to the doctor a year for your annual physical, as a lot of people ( people refer to it. And last thing I just thought I'd mention for our listeners is, a lot of folks take medicines quite frequently. You know, they get their script, they go to the doctor-- excuse me, they go to the pharmacy.
Prior to satisfying the deductible, Karyn, prescription drugs are treated like any other costs. So if you take a medicine monthly and it's an expensive medicine, you need to take that into account to determine if a high deductible health plan-- meets the needs of you and your family.
Karyn McCormack: Okay, good. Okay, getting back to HSAs-- how much can an employee contribute to an HSA?
Brian Dobbis: So health savings account contribution limits are based on inflation-- like, same as, a lot of the retirement accounts-- 401ks, IRAs. Therefore, the IRS has said in 2019, if you have coverage just for yourself, which is known as single coverage-- you can fund upwards of $3,500. If you have family coverage it's doubled to $7,000. And for our listeners, there is a catchup contribution of $1,000. However, you do need to be age 55. So it would be $4,500 maximum for single, $8,000 for family coverage, assuming you are age 55. And the 2020 limits, which the IRS just released-- they increased slightly to $3,550 and $7,100 for next year.
Karyn McCormack: Great. We talked about the variety of benefits that HSAs offer. Are there any drawbacks?
Brian Dobbis: Yeah. Now, to be certain, Karyn, there definitely are some drawbacks. So-- HSAs, although they offer a variety of benefits, tax and nontax, there are some drawbacks. 1) You must be enrolled in a high deductible health plan. So if your employer does not offer you one, unfortunately you're outta luck. You just cannot fund an HSA.
However, an increasing number of employers are beginning to offer high deductible health plans to help with cost sharing for medical expenses. In addition, the HSA can only reimburse medical expenses that were paid after the health savings account was established. And-- also another drawback, once you were enrolled in Medicare, which generally happens at age 65-- you no longer can contribute to an HSA.
Now Karyn, there are a couple other drawbacks that I think, you know, our folks should really take a deep dive into. As I mentioned a little while ago, a high deductible health plan does not pay out any benefits until you've satisfied your deductible. Or do you have money saved to cover the deductible and/or medical emergencies, if you don't find yourself in a position where your insurance isn't going to cover anything and you don't have the means to cover the deductible?
In addition, flexible spending accounts, which-- a lot of our listeners are probably familiar with. If you qualify for an HSA you cannot set up both an HSA and an FSA unless the flexible spending account is what's known, Karyn, as a limited purpose FSA. And for our listeners, a limited purpose FSA works just like a regular FSA, but can only be used for vision care and dental expenses.
Now Karyn, just a couple other things, just from a tax perspective-- you can take a distribution from an HSA at any reason-- for any reason at any time. But what happens if you take a distribution for nonmedical expenses? Well, then you would be assessed a 20% penalty and the distribution would be subject to income tax, federal and state.
Karyn McCormack: When an HSA owner turns 65 some new benefits kick in and others are lost. What are they?
Brian Dobbis: Yeah. Great question. So Karyn-- in the retirement world, with IRAs and 401Ks, the two big ages are 59 and a half and 70 and a half, whereas in the HSA side of the coin it's age 65. I mentioned this earlier; lemme reiterate it again. You lose HSA eligibility to make a contribution the first day of the month you turn 65 and enroll in Medicare. Enrollment in any Medicare coverage-- Part A, B, C, or D -- ends HSA eligibility.
Further-- the 20% penalty that I referred earlier is waived, Karyn-- so this is a good thing. So at age 65 or later, if you take a distribution from your health savings account for nonmedical expenses there's no 20% penalty. You still would be subject to income tax, but that is a a 20% waiver; pretty significant.
And you can use your HSA to cover Medicare premiums and long-term care insurance premiums, tax and penalty free. So an HSA can help offset future premium costs for both-- Medicare as well as long-term care. So again, a lot of changes. You'll gain some new benefits, you'll lose some benefits at age 65-- especially with the interaction with Medicare.
Karyn McCormack: Now, you just mentioned that-- at 65 the 20% penalty tax is waived. What's a situation where someone under 65 would be assessed a 20% penalty?
Brian Dobbis: Yeah-- I'm glad you brought that up, Karyn. Because-- health savings accounts are a lot like IRAs in regards to distribution flexibility. You can take a distribution from an HSA at any age, for any reason, at any time. However, if you utilize your health savings account for a nonmedical expense, then your distribution, including earnings, will be subject to income tax and a 20% penalty.
So therefore, if you're funding an HSA you really just kind of need holistically to look at your finances, because if you need to dip into your HSA to cover-- to fix your vehicle if your car broke down and you can't get to work, there is going to be quite the significant tax liability and a potential penalty.
Karyn McCormack: Okay. Now, let's look at how a health savings account is structured. How does it work exactly?
Brian Dobbis: Sure. So you know, we've discussed a lot today about-- drawbacks, the tax advantages, some of the other-- variables-- in regards to HSAs. But how do you set one of these up? What type of investments can you utilize? Can you use investments? Well, generally HSAs come in two flavors. One is referred to as a deposit account, and the second is referred to as an investment account.
A deposit account is generally your assets are in a money market or some type of cash equivalent, whereas an investment account, you can invest in mutual funds. And you can set up a portfolio and utilize an HSA how they were intended, to offset future medical expenses. Again, for our listeners, this is where your financial advisor can come in and assist you and guide you with a portfolio, to keep a certain amount of your HSA proceeds in a cash type of account for immediate medical expenses.
But then they'll have a portion for future medical expenses. And just a reminder to our listeners-- and I think this part, there's been some miscommunication, so hopefully I can clarify it.
You own, Karyn, your health savings account, just like you own your IRA. You own your health savings account. Therefore, you can take the account with you. Meaning, if you're unhappy with your current HSA provider you can transfer it tax-free to another provider that's maybe more friendly or offers-- more robust investments, or just a more robust platform.
Karyn McCormack: Yeah, I don't think people are really aware of that. That's very interesting.
Brian Dobbis: And I'll back that up with a statistic. Roughly about 85% to 90% of health savings account assets are invested in cash or some type of cash equivalent, whereas again, you can investment in mutual funds and other investments, and that's where the financial team, the accountant-- the advisor come together, to help you offset those future medical costs.
Karyn McCormack: Absolutely. Let's talk about rollovers. Can you roll over an HSA into a different HSA?
Brian Dobbis: Great question, Karyn. Thank you.
Yes, you absolutely can transfer tax-free from one HSA into another. Therefore, if for some reason you were unsatisfied with your current HSA provider, you can move the assets directly, tax-free to another HSA provider. Again, ladies and gentlemen, we urge you to do a direct transfer from one HSA provider to another to avoid taxation.
Karyn McCormack: And then what about-- estate and beneficiary planning for HSAs?
Brian Dobbis: Great question. So what happens when you pass away? What happens to your assets and your health savings account? Well, there's no restrictions on whom or what could be named the beneficiary of an HSA. Therefore, at death the funds remaining in your HSA are payable to the named beneficiary.
So ladies and gentlemen, upon establishing an HSA please make sure you designate a primary beneficiary. Now, most folks are going to name their spouse. The good news is, if you name your spouse as your HSA beneficiary, at your death your HSA will become your spouse's own. So you know, I pass away, I leave my wife, she now inherits my HSA and she can utilize it just like we've discussed today-- as her own, and use it for medical expenses.
My spouse can maintain the HSA in her own name, and distributions for qualified medical expenses will not be considered income. However, Karyn, if you do not want to leave your HSA to your spouse, or maybe you're single, then you're going to leave it probably to your kids, or your grandkids, or another family member. Non-spouse HSA beneficiaries do not fare very well. The account value of the HSA becomes taxable to the non-spouse in the year of death.
Therefore, if you know, Uncle Robert leaves me his $100,000 HSA, his favorite nephew, I then have $100,000 of income added to my tax return. For our listeners, there is no such vehicle as a stretch HSA, there's no such vehicle as an inherited HSA. Therefore, there's no method or strategy to defer taxation if you are a non-spouse beneficiary.
Karyn McCormack: Okay. Brian, thank you so much for speaking with us today on HSAs. On our website we have a three-part series that Brian wrote about HSAs, and it touches on rollovers, beneficiary planning, tax reporting, all the things we discussed today. Please check it out at LordAbbett.com. Also, we'd ask that you please speak with your financial advisor or tax professional to determine if health savings accounts are appropriate for you.
Brian Dobbis: Thank you for having me here today, Karyn. Appreciate it.
A health savings account is a savings account that lets employees set aside money on a pretax basis to pay for qualified medical expenses.
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