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The Benefits of Health Savings Accounts

Tax-Free Distributions for Eligible Expenses

 Alexandra  Armstrong In 2003 Congress passed legislation introducing health savings accounts.  At first much was written about these accounts, but few people actually signed up for them.  Then in 2006 new legislation was passed that made HSAs more appealing.  There are now many HSA plans to choose from, and we think they’re a good idea for some people.  Our clients have begun to ask whether an HSA is right for them, so we thought this would be a good topic to cover this month.

There are several types of tax-favored health savings accounts from which you can pay medical expenses while saving on taxes.  Besides the HSA, there’s the Archer medical savings account (MSA), flexible spending account (FSA) and the health reimbursement account (HRA).  But an HSA is the only one you can set up even if you’re not working.  Therefore, the focus of this article is HSAs as they apply to individuals wanting to establish these accounts. 

The Basics of HSAs

Once you open an HSA, you contribute money you’ll later use to pay your medical expenses.  The amount you contribute is deductible on your tax return.  The money grows tax-free while it’s in the account, and when you take money out to pay for qualified medical expenses the withdrawals are tax-free.  There’s no “use it or lose it” rule, nor are you required to take money out each year once you reach a certain age.  This means you can let the money accumulate tax-free until you really need it to cover medical expenses.

To be eligible for an HSA, you must also have a high-deductible health insurance plan.  You generally use an HSA to pay for medical expenses until you’ve met the deductible under your insurance policy, and then you use the insurance to cover additional expenses.  Because of the high deductible, you generally pay a lower premium for your health insurance than you would for a traditional plan, so the money you save on insurance premiums can be used to fund the HSA.

HSA Eligibility

You don’t have to have earned income to qualify, and there are no limitations based on your level of income.  There are only three basic requirements for being able to establish an account: 

•    You must have a high-deductible health insurance plan.

•    You can’t have any other comprehensive health insurance.

•    You can’t be claimed as a dependent on someone else’s tax return.

Since Medicare is a comprehensive health plan, once you enroll in it you won’t be able to open an HSA or add contributions to an existing HSA.  But if you already have an HSA when you enroll in Medicare, the money you’ve already put into your HSA can stay there and be withdrawn as needed.

An HSA can have only one owner, so joint HSA accounts don’t exist.  Therefore, if a husband and wife both want to have an HSA, they’d each have to open their own.

Defining a High-Deductible Health Plan (HDHP)

Before you can open an HSA you have to be covered by an HDHP.  This is a health insurance policy that has a higher-than-average annual deductible and meets IRS requirements.  For 2007 a policy covering an individual must have an annual deductible of at least $1,100 and an out-of-pocket limit of no more than $5,500.  For family coverage the annual deductible must be at least $2,200, and the out-of-pocket limit can’t exceed $11,000 (see table below).  The out-of-pocket limit includes deductibles and co-payments for in-network services.  If you go out of the insurance plan’s network, the out-of-pocket maximum can be higher.  HDHP premiums can’t be treated as an itemized deduction on your tax return. 

HSA Contributions

Contributions can be made by you, a member of your family or anyone else.  All contributions to your account (made by anyone other than an employer) are deductible by you as an above-the-line deduction on your federal tax return.  This means you don’t have to itemize your deductions to save on taxes.  Contributions can be made as late as April 15 of the following calendar year — the due date of your tax return without extensions.  This is the same due date as for IRA contributions.

The amount you can contribute depends on what type of HDHP coverage you have  (see table above).  If you have an individual HDHP policy, the maximum HSA contribution for 2007 is $2,850.  If you’re covered under a family pol-icy, you can contribute up to $5,650 to your HSA.  People age 55 or older by the end of the year can also make a catch-up contribution of $800 in 2007.  Contribution limits are set by the IRS, so they’re the same for all HSA plans.  The IRS announces by June 1 the new limits for the following year, giving you plenty of time to plan ahead.

For example, assume Nancy Smith turns 55 in December 2007.  She’s married, doesn’t work and is covered under her husband’s health insurance plan.  Her share of the premiums is costly ($400 per month), and Nancy isn’t happy with the coverage.  Further, because of their high income, the Smiths can’t deduct their health insurance premiums as an itemized deduction on their tax return.

To be eligible for an HSA in 2007, Nancy would have to opt out of her husband’s insurance plan and buy a high-deductible health insurance policy for herself.  The policy would have to have an annual deductible of at least $1,100 and an out-of-pocket maximum of no more than $5,500. 

She found a policy meeting these criteria for a monthly premium of $200.  If she changes to the HDHP coverage and it becomes effective by Dec. 1, 2007, she would be eligible to open an HSA and contribute the full $3,650 for 2007.  In their 28-percent federal tax bracket, this would save the Smiths $1,022 in federal taxes.  In addition, her insurance premiums would be $2,400 lower each year. 

The combined savings of $3,422 ($1,022 + $2,400) will cover most of what she’ll contribute to the HSA.  Nancy can then draw on the $3,650 balance in the HSA at any time to pay not only her own medical expenses but also her husband’s out-of-pocket medical expenses.

Choosing an HSA Plan

HSA plans are offered by banks, credit unions, insurance companies and other financial firms.  HSAs have many common features, such as an interest-bearing savings account (rates vary), a checkbook, a debit card and online access. 

HSA plans generally charge a monthly maintenance fee (about $3) as well as a one-time fee (usually $10 to $20) to open an account, though some plans waive their fees if you meet a minimum balance requirement.  Fees are charged for various optional services as well.  Some HSAs charge a fee if you close your account. 

Therefore, you should compare at least three different HSA plans, making sure to closely review each one’s schedule of rates and fees.  You don’t have to choose the HSA plan that the insurance company recommends — you can choose whichever one you want.  And if you later decide you want to change to a different plan, you can roll your account balance from one HSA plan to another.

Some plans give you the option of investing your money in stocks, bonds or other investments.  There’s nothing wrong with doing this, but it’s important to remember your investments may lose money.  In one sense you should consider your HSA a long-term venture, but you’ll probably need to tap it in the short term.  When medical expenses arise, particularly unexpected ones, worrying about whether it’s a “good” time to sell something in the HSA may be the last thing you’d want to grapple with.  Therefore, we suggest you do your investing in personal and retirement accounts and keep the money in the HSA liquid by putting it in an interest-bearing savings account. 

Taking Money Out of Your HSA

HSA distributions can be taken at any time and are tax-free if used exclusively to pay qualified medical expenses of the account owner or the owner’s spouse and dependents.  You can also reimburse yourself later if you used non-HSA money to pay for a medical expense. 

It’s important to keep receipts to back up your HSA distributions.  You may need to submit them to your insurance plan to receive credit toward meeting your deductible.  You may also need them if the IRS ever knocks on the door.  Distributions not used to pay for qualified medical expenses are taxable and are subject to a 10-percent penalty tax.  If a nonqualified distribution is made after age 65 or upon the owner’s death or disability, the penalty is waived but the distribution will still be taxable.

Qualified Medical Expenses

Qualified expenses include things such as doctor and hospital fees, dental and vision expenses and prescription drug costs.  An HSA can also be used to pay for certain nonprescription drugs.  Money from the HSA can’t be used to pay your HDHP premiums and generally can’t be used to pay for any other health insurance premiums.  But it can be used to cover Medicare premiums paid by you or your spouse after age 65.  It can also be used to pay a limited amount of long-term care insurance premiums.  Ask your HSA plan to provide you with a list of qualified expenses; sources for additional information are at the end of this article.  You, not the HSA provider, are responsible for determining which expenses are qualified and which aren’t.

What Happens to Your HSA When You Die

At your death your account becomes the property of the beneficiary you named on the HSA.  If this is your spouse, he or she will be treated as the new HSA owner, and qualified distributions will continue to be tax-exempt.  If the beneficiary is someone other than your spouse, the account balance is taxable to the beneficiary in the year of your death. 


In this era of consumer-driven health care, more choices are available, but we have to work harder to be sure we’re making the right choices.  We’ve given you the basic information on HSAs, but you’ll need to do more research and some number crunching to decide whether this type of account makes sense for you.  As always, we recommend you ask your financial adviser for help before you make your final choice of plans. 

Alexandra Armstrong is a certified financial planner practitioner and chairman of Armstrong, Fleming & Moore, Inc., a registered investment ad­visory firm located at 1850 M St. N.W. in Washington, D.C. Securities are offered through Commonwealth Finan­­cial Net­work, a member of ­FINRA/ SIPC. Investment advisory services are offered through Arm­strong, Flem­ing & Moore, Inc., an SEC-registered investment adviser not affiliated with Common­wealth Fin­ancial Network.
Consult your personal financial ad­viser before making any decisions.
Ms. Armstrong can’t answer individual questions, but she welcomes suggestions for future article topics.

This material has been provided for gen­eral informational purposes and does not constitute either tax or legal ad­vice. Investors should consult a tax or legal professional regarding their in­di­vidual situation. The fifth edition of On Your Own: A Widow’s Passage to Emotional and Financial Well-Being,
co-authored by Alexandra Armstrong and Mary R. Donahue, is available on Amazon. com, Kindle and Nook.

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