In 2003, the federal government designed a new type of account, called a health savings account (HSA), to make it easier for some people to afford health insurance. Those who are eligible can reduce health insurance premiums and save tax dollars, too.
HSAs join a list of other set-aside accounts that may save us tax liability on certain expenditures. First, flexible spending accounts (FSA) allow you to set aside money for important things like health expenses or day care. Medical savings accounts are also available for some people. But for both of these kinds of accounts, at the end of the year, if you have not spent the money you save, then you forfeit it. Because of the forfeit rule, many people won't consider setting up those kinds of accounts. Why would they risk losing their savings?
That's why a health savings account can be so useful. It's a way of saving money to be used for health expenses, knowing the money will never be forfeited just because it isn't used by December 31.
HSAs Are Used Together With High-Deductible Health Insurance Plans
Only someone who chooses a high-deductible or catastrophic health insurance plan can take advantage of an HSA. As health insurance premiums have gone up, more high-deductible plans are being offered by employers. They are very likely available to those who are self-employed, and those who must purchase individual insurance.
The idea, then, is to choose a high-deductible plan, pay a lower premium for the insurance, and put the difference into an HSA to pay for the care the insurance won't cover. The money is saved from pre-tax dollars so no income tax is paid on those dollars.
How high does that insurance deductible need to be? For 2014, an individual must choose a plan with a deductible of $1,250 or more. The deductible for a family must be a minimum of $2,500.
Here's an example of how an HSA works:
Say you have a choice between a $500 deductible plan that costs $1,000 a month, or a $2,500 deductible plan that costs $500 a month. It's tempting to choose the lower premium, but scary to think of getting hit with needing to pay $2,500 out of pocket. So choose that higher deductible and its lower premium, then save $2,500 during the year in an HSA using before-tax dollars. It will save you several hundred dollars in taxes, plus you'll have access to that savings account for any potential healthcare expenses.
The money is yours to keep from year to year, and is portable from employer to employer, or location to location, until you need to withdraw it for your medical expenses. It won't be forfeited for non-use. Further, you never pay taxes on that money as long as it's used only for medical expenses.
As you incur a qualified medical expense, anything from a doctor's appointment, to a medical test, to prescription drugs, even some complementary or alternative forms of medicine, you can use money from your HSA as long as you aren't reimbursed by your health insurance.
HSAs are a good choice for some people, but make little sense for others. If healthcare is not a big expense for you, an HSA may work well. You'll be shifting the bulk of your health dollars to money you can save and use later when you really need it. You will send less to insurance companies where it will just disappear if it never gets used.
Most people who have higher medical costs won't find an advantage to using an HSA. Often the higher deductible plans are accompanied by higher co-pays and other limits, so any advantage through the use of the HSA is lost on those expenses. There may still be some tax advantage. You'll need to crunch some numbers or talk to your tax advisor to see if an HSA will save you money.
Setting up the savings account is quite easy. They are offered by some employers, but more likely you'll find your insurance company, bank, credit union or other financial institutions will set one up for you.
As is true for so many of these plans, there are plenty of rules and limits about who can participate, who can contribute to your account, how the money may be used, and how much can be saved or spent. Ask someone in your employer's human resources department to help you with the rules, and to help determine if an HSA makes sense for you.