By Philip van Doorn, MarketWatch
This article was first published in May and has been updated with new HSA contribution limits for 2020 and other numbers.
Put in some extra time when you next select your health insurance plan, and you may find you can pay much lower premiums while also reducing your health-care costs for the rest of your life.
Whether you have health insurance through your employer or purchase coverage through an exchange set up through the Affordable Care Act of 2010, the combination of a lower-cost, high-deductible health insurance and a health savings account may provide great advantages. You save on taxes immediately, the money can be invested for decades, and — unlike with an IRA or 401(k) account — you may never have to pay taxes on any of it.
Health savings accounts are different from flexible spending accounts
People often refuse to consider opening a health savings account because they believe it is a flexible spending account. The two are very different.
A flexible spending account, or FSA, is offered through your employer’s health insurance and allows you to set aside up to $2,700 in pretax money (the Internal Revenue Service can raise the limit each year). That money must to be used for eligible out-of-pocket health-care expenses for you and your family that tax year or it is lost , except for $500 that the IRS lets you carry over to the next year . So the FSA can be useful if you have a good idea how high your out-of-pocket expenses will be, and if you don’t contribute too much.
A health savings account (HSA) works differently. First, you’re only eligible if you have a high-deductible insurance plan. Second, you can shelter much more money from taxes. Up to $3,550 (for an individual) or $7,100 (for a family) in pretax money is withheld by your employer (or set aside by you, especially if you buy your own health insurance) and placed in an HSA each year. (Those are the 2020 limits. Again, the amounts can change every year.)
Like the FSA, you can use money in the HSA to pay for out-of-pocket health-care expenses tax-free. But the HSA doesn’t have a “use it or lose it” feature.
The beauty of this is that an HSA can work as another way to save money for retirement, especially health-care expenses in retirement. And because you can invest and let the money build up over the years, you can capitalize on the magic of compounding. That $3,550 or $7,100 you set aside this year could double in nine years if you earn a 8.9% average return — which has been the average compounded annual growth rate for the S&P 500 index /zigman2/quotes/210599714/realtime SPX -0.30% over the past 15 years, according to FactSet.
Of course, this assumes you have the ability to pay for today’s out-of-pocket expenses with other funds.
An opportunity to increase tax-deferred savings may be especially important if you are self-employed or if no employer-sponsored retirement account is available to you. Federal law allows a person with a 401(k) or similar employer-sponsored retirement account to put away up to $19,000 in pretax dollars (plus another $6,000 if you are 50 or older) each year. But the limit for individual retirement account (IRA) contributions is only $6,000, plus another $1,000 if you are 50 or older. (Those are the 2019 limits. The 2020 limits are expected to be announced in November.)
If you buy your own insurance through an exchange, you might find a high-deductible health plan, known as an HDHP, much more affordable than a low-deductible plan. Of course, the same might be true for health insurance arranged through an employer.
David Mendels, director of planning with Creative Financial Concepts in New York, said that for people buying an HDHP through an exchange, an HSA is “an absolute no-brainer. You are going to get the tax deduction, you are still going to get the money, and you can get it out tax-free.”
There’s also the potential for free cash from your employer. Many match contributions into an HSA up to a certain limit. In its year-end HSA research report , Devenir (which provides investment services to HSA administrators) estimated that the average employer contribution to an HSA increased to $839 in 2018 from $604 in 2017.
Here’s how you avoid taxes when you take out the money
Once you are 65, you can withdraw money from your HSA for any purpose, rather than just to cover health costs. If you spend it on qualified health-related expenses, the withdrawal is tax-free, as it is at any age. If you take money out for another reason, you will have to pay income taxes.
You might even “reimburse yourself,” tax-free , for qualified medical expenses you had paid for out-of-pocket in earlier years. Not tapping your HSA for out-of-pocket expenses now means you can enjoy the benefit of tax-deferred growth longer while still claiming the benefits of tax-free health-related spending.
Unlike an IRA or 401(k) account, there is no required minimum distribution from an HSA at age 70 1/2. Considering how likely it is for you to have high medical expenses later in life, it is quite likely that some or all of the HSA money will never be taxed.
Ask yourself these questions
To participate in an HSA, you need to be enrolled in a high-deductible health plan, which means the annual deductible needs to be $1,400 for an individual and $2,800 for a family. The HDHP’s annual out-of-pocket maximum cannot exceed $6,900 for an individual or $13,800 for a family. (Those are the 2020 numbers).
The higher deductibles and higher potential out-of-pocket maximum figures may be a little scary. However, this is where a potential opportunity lies.
Here are questions you should answer as part of your HSA decision-making process:
• How much would you save in premiums if you participated in a high-deductible health insurance plan instead of a more expensive plan with lower deductibles?