Health Savings Accounts: Questions and Answers
If you’re concerned about the high cost of health insurance, you may be interested in learning more about health savings accounts (HSAs). An HSA is a tax-advantaged savings account that’s paired with a high-deductible health plan (HDHP) to help you pay your current health costs and save for future ones. The HSA/HDHP option is part of a growing trend toward consumer-directed health care, and is becoming more popular with employers and individuals as a flexible alternative to traditional health insurance.
How does an HSA work?
You can open an HSA only if you’ve also enrolled in an HSA-eligible HDHP, either on your own or through your employer. An HDHP is “catastrophic” health coverage that pays benefits only after you’ve satisfied a high annual deductible (some preventative care, such as routine physicals, may be covered before the deductible is met). For 2006, the annual deductible must be at least $1,050 for individual coverage and $2,100 for family coverage.
Once you’ve satisfied your deductible, the HDHP will provide comprehensive coverage for your medical expenses (though you may continue to owe co-payments or coinsurance costs until you reach your plan’s annual out-of-pocket limit). A qualifying HDHP must limit annual out-of-pocket expenses (including the deductible) to no more than $5,250 for individual coverage and $10,500 for family coverage (for 2006). Once this limit is reached, the HDHP will cover 100% of in-network costs.
Because you’re shouldering a greater portion of your health-care costs, you’ll usually pay a much lower premium for an HDHP than for traditional health insurance, allowing you to contribute the premium dollars you’re saving to your HSA. Your employer may also contribute to your HSA, or pay part of your HDHP premium. Then, when you need medical care, you can withdraw HSA funds (usually by debit card or check) to cover your expenses, or opt to pay your costs out-of-pocket if you want to save account funds for future medical expenses. There’s no “use it or lose it” provision, so funds roll over from year to year. And the account is yours, so you can keep it even if you change employers or lose your job.
What tax savings opportunities exist?
HSAs offer several major tax benefits. Contributions made by or through your employer may come out of your salary pretax, reducing your current income tax. Contributions you make on your own (if you’re self-employed, for example) are deductible from your federal income tax (and perhaps from your state income tax) whether you itemize or not. You can also deduct contributions made on your behalf by family members. HSA contributions, and any interest or earnings, grow tax deferred until withdrawn, and will be tax free when withdrawn if they’re used to pay qualified medical expenses.
Who can open an HSA?
Any eligible individual who has qualifying HDHP coverage can open an HSA. However, you can’t open an HSA if you’re already covered by another health plan (although some types of specialized health plans are exempt from this provision). You’re also out of luck if you’re 65 and eligible for Medicare or if you can be claimed as a dependent on someone else’s income tax return.
How much can you contribute to an HSA?
Each year, you can contribute as much as 100% of your annual HDHP deductible, but your contributions can’t exceed a certain limit (for 2006, $2,700 for individual coverage and $5,450 for family coverage). This limit applies to all contributions, whether they’re made by you, your employer, or your family members. If you’re 55 or older, you may also be eligible to make “catch-up contributions” to your HSA, but you can’t contribute anything once you reach age 65.
Can you use HSA funds to pay for prescription drugs?
Yes. You can use your HSA funds for many types of health-care expenses, including prescription drugs, eyeglasses, deductibles and co-payments, and premiums for specialized types of insurance such as long-term care or disability insurance. IRS Publication 502 contains a list of allowable expenses.
What about using HSA funds for nonmedical expenses?
You can, but think twice about doing so; you’ll pay a 10% penalty if you withdraw money and use it for nonqualified expenses, and you’ll owe income taxes as well. At age 65, this penalty no longer applies (even if you use your HSA funds to supplement your retirement income), but you’ll still owe income taxes on money used for nonqualified expenses.