Health Savings Accounts: Desirable, Despite the Complexity

Healthcare continues to be one of the most significant expenses you will incur during your retirement. A study by Fidelity shows the average couple will need $280,000 in today’s dollars for common medical expenses in retirement.  If you pay an Income Related Monthly Adjustment Amount (IRMAA) for Medicare or incur long-term care, the amount needed can grow significantly.

You may ask why health care costs are a bigger concern now than when our parents retired. Here’s what we think:

• Healthcare costs are increasing faster than inflation.
• Few have access to employer-sponsored benefits that are less expensive than Medicare.
• IRMAAs increase your premiums.
• Life spans are longer.
• Families are not able to help financially or physically.

To help individuals manage their health care costs, Congress passed a bill in 2003 setting up Health Savings Accounts, known in short as HSAs.  We find HSAs very enticing because they have a triple tax advantage.  Let me repeat—a triple tax advantage. This is as good as it gets.

Triple Tax Advantage

1. Pre-tax contributions
2. Tax-deferred growth for the investments
3. Tax-free withdrawals for Qualified Medical Expenses (QMEs)

Your retirement accounts only offer two tax advantages, not three. Take 401k plans as an example. 401k plans provide pre-tax contributions and tax-deferred growth but withdrawals are taxed.  Roth IRAs grow tax-free and are withdrawn tax-free, but contributions are made after you’ve paid tax on those dollars.  HSAs enjoy all three tax advantages.

We find it can be helpful to think about an HSA as another one of your retirement accounts, only specially designed to cover medical expenses. If you can afford to do so, here is a simple strategy.

• Fund your HSA each year up to the maximum allowable amounts.
• Leave your HSA dollars alone to compound over the years and pay your unreimbursed medical expenses with after-tax dollars.
• Invest the money in the HSA account for the long term, just as you would your 401k or other long-term retirement accounts.
• In retirement, use your HSA to pay for qualified medical expenses.

Qualifications to Open / Fund an Account

• You must be covered by a High Deductible Healthcare Plan (HDHP) that meets specific out-of-pocket dollar requirements.
  • Your human resource department or insurance agent can tell you if your health care plan is HSA compatible.
  • Medicare is not an HDHP; more on this later.
• You cannot be claimed as a dependent on another person’s tax return.
• Annual contributions are limited.
  • 2018 Individual: $3,450
  • 2018 Family: $6,900
  • Contributions are indexed for inflation each year.
  • $1,000 Catch-up contribution if over age 55
  • Employers and individuals can make contributions.
• Accounts are set up by the participant and administered by a financial institution or insurance company.
• Monies can be invested in cash, CDs, stocks, bonds, and mutual funds.
• Excess contributions have a 6% per-year excise tax until removed from the account.
• Distributions not used to pay or reimburse QMEs will be taxed at your ordinary income tax rate plus a 20% penalty.
  • Exception: no penalty if you are over age 65

Qualified Withdrawals

In order for your withdrawals to be tax free, you’ll need to match them with Qualified Medical Expenses (QMEs) which are defined in 2017 IRS Publication 502, Medical and Dental Expenses.

Deductible QMEs are:

• Medical expenses for you, your spouse and your dependents,
• Medicare Premiums for Part B (medical), Part D (prescription) and Part C (Medicare Advantage),
• A portion of Qualified Long-Term Care insurance,
• COBRA premiums,
• Insurance premiums while receiving unemployment benefits.
• Examples of items that are not QMEs:
  • Standard health insurance premiums,
  • Medi-Gap/Supplemental Medicare premiums.

Important details

• Medigap insurance premiums – These premiums are NOT QMEs and therefore are not reimbursable.
• If your health insurance is no longer HDHP – You can no longer make contributions to your HSA.  You can take reimbursements from your HSA.
• Dependents?  – The Affordable Care Act allows children up to the age of 26 to be included on their parent’s health insurance plans, regardless of whether or not they are dependents on the parent’s tax return.  While they may be on your health insurance plan, if they are not a dependent on your tax return, their expense are NOT qualified medical expenses.
• Use it or Lose it?  – Reimbursement does NOT have to happen in the same year as the expense.  The medical expense must be incurred when you have an HSA account open.  Reimbursement can happen at any time before death – see exception later.
  • This is an excellent tool for managing your tax brackets because the reimbursement (withdrawal) is tax-free.
  • For example: If you open an HSA in 2003 and fund it each year, never taking a withdrawal, you can reimburse yourself in 2018 for any / all of the post-2002 QMEs you have documentation for.  With this reimbursement, you have more money in your pocket without paying additional taxes.
• Keep all medical receipts for which you think you may eventually want reimbursement.
• When you take a withdrawal, save the medical receipts the withdrawals cover.  We suggest keeping them in your tax folder for the year in which you make the withdrawal.  You will need them if audited.
• If you take an itemized deduction for a medical expense on your tax return, you cannot double dip and also receive money from your HSA to cover the cost. (Taking a deduction for medical expenses is rare because 1) your medical expenses must exceed 7.5 / 10% of your AGI in order to take the deduction and 2) with the new tax law many of you will no longer itemize.)

Medicare Complications

• Medicare is not an HDHP.
• You cannot contribute to an HSA if you are on Medicare.
• Age 65 – Enroll in Medicare.
  • Stop HSA contributions the month before you enroll.
• Over Age 65 – Enroll in Medicare.
  • When you apply for Social Security, you are required to enroll in Medicare Part A.
  • Medicare will retroactively enroll you in benefits to the earlier of 6 months or your 65th birthday.
  • Stop HSA contributions the month before the retroactive date.
• Over Age 65 – When enrolling in Medicare, decline retroactive benefits.
  • Sign up for Medicare in person or via phone call – not online.
  • Be very specific instructing the enrollment representative that you do NOT want to be enrolled for any retroactive benefits.
  • Make a note of the time and date of your conversation and with whom you spoke.

Death of the HSA Owner

Similar to your retirement accounts, you need to name a beneficiary for your HSA account. The disposition of the account is based on the beneficiary designation.

• Spouse
  • Account is retitled in your spouse’s name.
  • Contributions and withdrawal rules apply as if your spouse created the account.
• Non-spouse
  • Entire account is taxable as ordinary income to the beneficiary in the year of the owner’s death. (No additional penalty.)
  • Tax-free withdrawals are available for any QMEs for the deceased that are paid by the beneficiary within one year of the date of death.
• Estate
  • Entire account is taxable on the deceased HSA owner’s final return. This option may make sense if the taxpayer is in a lower tax bracket than the person they would name as a beneficiary.
• Charity
  • Entire account is given to the charity, and no tax is due from the HSA owner or the charity.

Remember, a triple tax advantage is only available with an HSA account. If you don’t have an HSA and your health insurance is an eligible HDHP, we suggest you open an account.  Name your beneficiaries. Fund your account to the maximum amount each year.  Stop contributions when you are no longer eligible.  Be careful when coordinating HSA contributions and Medicare. Moreover, remember to use your account in your later years.  We hope this information gives you the knowledge to understand the rules and how to use them to help you.

This information is believed to be accurate but should not be used as specific investment or tax advice. You should always consult your tax professional or other advisors before acting on the ideas presented here.