HEALTH SAVINGS ACCOUNTS (HSA)

AN OVERVIEW

What is an HSA?

A Health Savings Account (“HSA”) is a tax-advantaged program which was established in 2004 as a savings plan for healthcare needs.  To obtain an HSA, the taxpayer must also participate in a high-deductible health plan (“HDHP”).  In fact, there are two independent components to the HSA program: the actual HSA savings account and the associated HDHP insurance.  The HSA is held at a bank, while HDHP coverage is available from most mainline health insurance companies.  The impetus of the HSA program is to allow/require participating individuals to make independent decisions on their health care spending.  Distributions from the HSA for qualified medical expenses are tax-free.

 What are “qualified medical expenses?”

The IRS offers general information about what qualifies as a medical expense in Publication 502, beginning on Page 5 (IRS Pub 502).  The list is broadly defined, covering common medical situations.  (It specifically excludes certain personal expenses, such as health club dues, nutritional supplements – if not prescribed, face lift procedures, personal-use items, etc.)

 Qualified expenses also include insurance premiums for long-term care insurance (LTC), COBRA, and coverage while an individual receives unemployment compensation.  The HSA can also be used for Medicare Part A or B premiums and Medicare HMO if the individual is over age 65.

 HSA Advantages:

Tax Deduction, Tax-Free Growth, and Tax-Free Distributions

The tax advantages of HSAs are substantial: contributions to the account are deductible, the earnings on the contribution grow without being taxed, and the withdrawals are tax-free if used for qualified medical expenses. In other words, the money placed in the HSA is never taxed if used for medical purposes. This degree of advantage is unprecedented in the tax code.

 Distributions

Individuals over age 65 can take distributions from the HSA for any reason without incurring a 10% penalty.  Distributions for qualified medical expenses remain tax-free and other non-qualified distributions count as ordinary income to the individual (similar to a Traditional IRA arrangement).  In addition, there is no time limit for HSA withdrawals – unlike the Traditional IRA mandatory required distribution after age 70.5.

 Health Plan Costs

High-deductible health plans generally cost 20 to 30% less than comparable insurance plans.  The cost varies substantially between providers based on individual health status, age, deductibles, and benefits.  HDHPs may not offer any cost advantage for individuals with access to a group rate or employer-subsidized rates.  Instant, anonymous quote comparisons can be obtained by entering a zip code, birth date, and sex into http://www.ehealthinsurance.com/ (click on the “HSAs” tab at the top of the second webpage for qualified HDHP plans).

 Tax-Free Growth

Obviously, the largest financial benefit occurs if an individual does not tap the HSA for medical expenses by 1) remaining healthy and not incurring healthcare expenses, or 2) having sufficient liquidity to pay for HDHP co-pays and deductibles through cash flow.  As an example, assume a 40-year old contributes $2,850 to his HSA this year.  If he does not make any distributions from the HSA and the money compounds at 6% per year, the original contribution will grow to $12,231 by age 65.  However, if he spends $1000 of the $2,850 HSA contribution on medical expenses, the remaining savings will only grow to $7,940 at age 65.

 No Income Limits

One further advantage to the HSA plan is that there is no requirement for earned income to participate, nor any AGI limitations.

 HSA Disadvantages:

Management and Record Keeping

Participation in an HSA requires more individual effort than a traditional plan.  Participants must determine whether their medical expenditures are deemed as “qualified” and track their medical spending throughout the year.  Individuals must report contributions to their HSA account on Form 8889 (IRS Form 8889) when filing their annual tax return.  A participant must also choose which investments to hold in the HSA account.  For example, HSABank.com features access to “stocks, bonds, and over 11,000 mutual funds” as investment options.  Thus, the management responsibility and record keeping burden is substantially higher than with traditional health insurance.

 Liquidity

Individuals need more of a liquidity buffer with an HSA plan.  The concept of an HSA is to save money on premium payments by setting a high ceiling on out-of-pocket expenses, shifting some responsibility from the insurer to the individual.  So long as medical expenses are low, the arrangement pays off.  However, as many medical expenses are unanticipated, the individual must always be prepared to pay the maximum out-of-pocket expense (less the HSA contribution amount) from liquid assets.  This is due to the fact that statutory out-of-pocket expenses exceed the annual HSA contribution limit.   

2007 Individual Statutory Limits

As stated above, the maximum financial benefit from an HSA plan occurs when all HDHP expenses are paid from liquidity, allowing the full HSA contribution to compound tax-free.  This implies that the individual has sufficient annual savings to fully fund the HSA plan, pay the HDHP premium, and liquidity to cover the maximum HDHP out-of-pocket expense from cash flow.  In addition, preventative medicine may not fall within the particular HDHP policy, requiring further liquidity to cover this common expense.

 Non-qualified Withdrawal Penalty

If an individual makes distributions from an HSA for non-qualified expenses and is under age 65, the distribution will be taxed at ordinary income rates and also subject to a 10% withdrawal penalty (similar to a Traditional IRA).  Therefore, an individual should not consider tapping HSA balances for liquidity needs. 

 Death of the HSA Owner

If an HSA owner dies and has selected his/her spouse as the beneficiary, the account will be transferred to the spouse without tax consequences.  If the beneficiary is not a spouse, then the HSA account is liquidated at fair market value and becomes ordinary income to the beneficiary.  If no beneficiary is selected, the account will be included in the estate’s tax return.  

 SPECIFICS

2007 Statutory Limits

*NOTE:  the maximum HSA contribution is the lesser of the annual HDHP deductible or the statutory limit above.  Therefore, an individual should only select an HDHP with a deductible equal to the statutory limit to maximize the HSA plan.  Minimum deductibles required for an insurance plan to qualify as an HDHP policy are also listed in the table.   

Individuals over age 55 may contribute an additional $800 to the HSA in 2007.

Contributions

Contributions can be lump sum; however, an individual cannot contribute more than the annual maximum based on their monthly eligibility.  A person is deemed eligible for the month if, on the first day of the month, they participated in a qualified HDHP plan and did not having any disqualifying coverage.  Disqualifying coverage includes Medicare Part A or B, medical VA benefits, or TRICARE (for military).  For example, the maximum 2007 individual contribution is $2,850 (12 months of eligibility at $237.50 per month).  Any excess contributions are subject to a 6% excise tax.

 The contribution limits are increased annually for inflation.

 Contributions can be made until April 15^th the following year, with an election made to the previous tax year.

 Residency in the U.S. determines eligibility for an HSA – the individual does not have to be a citizen.

 Contributions can be made to more than one HSA account, but the total contributions made to all accounts cannot exceed the single annual maximum.

 Dependents cannot have their own individual HSAs, but spouses may.

HSA EXAMPLE

 A 40-year old man with a wife and two dependent children wants to compare a family HSA plan against traditional PPO coverage.  The details of each plan are listed in the tables below.  In the first scenario, the family requires four trips to the doctor’s office and only one prescription per month.  By choosing the HSA plan, the family saved $1,560 this year through paying lower premiums for the HSA.  (There may be an additional tax benefit to owning the HSA if the individual was not able to deduct the PPO premiums as part of an employer sponsored cafeteria plan.)  In the second scenario, one of the family members has to be hospitalized during the year, which costs $25,000.  In this case, the greater out-of-pocket expenses of the HSA plan exceed the premium savings; the HSA plan costs the family $1,920 more than the PPO plan. 

SCENARIO 1

SCENARIO 2

REFERENCES

 General HSA Information and Updates  http://www.hsafinder.com/

                                                               http://www.hsainsider.com/

Health Savings Account Providers (representative list of banks offering investment selections)                

 Health Savings Administrators               http://www.hsaadministrators.com/  (20 Vanguard no-load funds

  HSA Bank                                           http://www.hsabank.com/ (complete Ameritrade brokerage access)

 JP Morgan Chase                                 http://www.chase.com/ (9 JP Morgan mutual funds available)

 Wells Fargo                                          https://www.wellsfargo.com/ (6 mutual funds available)

HDHP Plan Comparison and Quotes      http://ehealthinsurance.com/

IRS Publication 969 - HSAs                   http://www.irs.gov/pub/irs-pdf/p969.pdf

Internal Revenue Code and Publications  http://www.irs.gov/

CCH Incorporated’s Top Federal Tax Issues for 2007, Chapter 6, was used extensively for this article.  ISBN 978-0-8080-1532-1.  www.CCHGroup.com