To have a health savings account (HSA), you generally must be covered by a high-deductible health plan (HDHP) at work. HDHPs have become popular in recent years as employers have struggled to keep health benefit costs down. If you’re not covered by one now, you might be soon, as more employers consider the advantages. Also, if your employer gives you multiple health plan options, one of them might be an HDHP. Understanding the benefits of HSAs might make the HDHP more attractive. 

There’s a key to making an HSA work. You need to be able to pay the medical expenses you incur before you hit your HDHP’s deductible, without dipping into your HSA. If you’re operating on a tight budget, this may not be practical, even with the big tax benefit.

High-Deductible Plan Rules

To qualify as a HDHP, a health plan’s deductible for single coverage must be at least $1,400 in 2020 (up from $1,350 in 2019), but no higher than $6,900 in 2020 (up from  $6,750 in 2019), for all out-of-pocket expenses (including copays and coinsurance). For family coverage, the limits are $2,800 and $13,800 respectively in 2020 (up from $2,700 and $13,500 in 2019).

If you’re eligible for an HSA, your employer may have established an arrangement with a financial institution to hold that account. Alternatively, you can set one up on your own.

There are two non-exclusive ways to fund an HSA. The first is to arrange to have contributions deducted from your paycheck on a pre-tax basis and deposited in the account. For 2020, the HSA contribution limit for single coverage is $3,550 (up from $3,500 in 2019). For family coverage, the limit is $7,100 in 2020 (up from $7,000 in 2019). And if you’re 55 or older, you’re allowed an extra “catch up” contribution of $1,000.

The second way to fund an HSA is through employer contributions, either directly or via a “cafeteria” plan. The annual HSA contribution limits noted above apply to the sum of contributions from all sources. So, for example, if you have family coverage and your employer contributes $3,000 to your HSA, you can add no more than $4,000 for a total of  $7,000.

Note: Once you enroll for Medicare, Part A or Part B, you can no longer contribute to your HSA, though you can continue to use the money in your account.

Timing Flexibility

As with IRA contributions, you have until the tax filing deadline for a given year to make the previous year’s contribution. This means you have until April 15, 2020 to max out on your 2019 contribution.

HSA account-holders typically tap their accounts to reimburse themselves for “qualified” medical spending. IRS Publication 502 goes into detail about the expenses that are considered qualified, but they generally include dental, prescription and vision services.

According to the IRS, “Medical expenses are the cost of diagnosis, cure, mitigation, treatment, or prevention of disease, and for the purpose of affecting any part or function of the body.” On the other hand, “expenses that are merely beneficial to general health, such as vitamins or a vacation,” aren’t considered qualified.

Funds that you withdraw to pay for qualified expenses aren’t taxed. But if you use the funds for nonqualified expenses, you’ll owe income tax on that amount as well as a 20% penalty. However, if you’re 65 or older, the 20% penalty doesn’t apply.

Postpone Paying Yourself Back

HSA rules don’t set time limits on when you must reimburse yourself for qualified expenses. This flexibility enables you to use your HSA to save for retirement. Suppose you’re 40 years old, have an HSA through work, and you decide to stop reimbursing yourself for out-of-pocket qualified medical expenses. Suppose also that between your contributions and those your employer makes, you contribute additional money every year to your HSA and let it grow. (You can also reimburse yourself for expenses as they occur and put the funds in a stable but liquid investment or savings account.)

Investing $3,500 a year for 25 years in an HSA (and possibly increasing your annual savings amount over time) with average returns slightly above 6%, could add up to $200,000. After age 65, you can withdraw those funds tax-free. Note that you’ll need to match the funds you withdraw from your account with qualified medical expenditures — so be sure to keep good records and receipts.

What happens if you wind up with a bigger account balance than your accumulated unreimbursed medical expenditures? You’ll only need to forfeit a portion of that supplemental nest egg to income taxes.

Last Words

If you haven’t considered an HSA in the past, this might be a good time to take another look. Talk to your human resources advisor. While this type of account isn’t right for everyone, an HSA could provide flexibility and tax advantages not available elsewhere. IRS publication, Publication 969, discusses HSAs in greater detail.