Tax-savvy use of a Health Savings Account

health-savingsThis article appeared in Forbes.

More workers than ever are being offered (or pushed into) high deductible health plans at work. While having to pay hundreds or even thousands of dollars in deductibles may sound off-putting at first, there’s a silver lining: these plans often come with an optional health savings account. For savvy savers, it’s an incredible hidden way to prefund healthcare costs in retirement.

“The tax advantages don’t get any better,” gushes Christopher Goldsmith, vice president at Sibson Consulting in Cleveland. “HSAs are a wonderful way for Americans to accumulate a health care nest egg.”

Here’s how they work. Both you and your employer can contribute to a health savings account on an annual basis—a combined total of $3,100 next year for an individual or $6,250 for a covered family. (Those 55 and older can put in another $1,000.) The money you contribute reduces your taxable salary, meaning thousands in tax savings for high-income folks. When you take the money out for medical expenses–now, or in retirement– it comes out tax-free. (There’s a 20% penalty if you use the money for non-medical expenses before 65; once you turn 65, you can use HSA money for nonmedical expense, but you’ll owe income taxes if you do.) Like a 401(k) retirement account, the HSA is yours to keep. You can invest it, and it grows tax-free.

When employers first roll out high deductible health plans, they will often kick in $1,000 or more into employees’ HSAs to get employees used to the idea of a high deductible (some employers keep contributing every year). You’re basically paying out of pocket for everything other than preventative care up to the deductible, so using the tax-advantaged HSA money bridges the gap. “It’s a different mindset writing a check for $300 instead of $20 [with an HMO or PPO health plan],” says Susan M. Nash, an employee benefits lawyer with McDermott, Will & Emery in Chicago.

You can choose to use the money in your HSA to cover the $300 bill, or you can pay the $300 bill out-of-pocket and let the HSA money accumulate. To the extent you don’t use the money in the HSA to pay for medical expenses while you’re working, or you use your healthcare dollars wisely so you have money left over at the end of the year, you have it saved up for retirement. And if you don’t use it in retirement, you can pass it on to your heirs.

Employers might condition their contribution to your HSA on your filling out a health assessment or taking a biometric screening. Some employer contributions are set up as matching contributions. Don’t leave this “free money” on the table.

Despite the tax advantages of HSAs, 37% of folks who were eligible for an HSA do not have one, according to the Employee Benefits Research Institute. Why aren’t these accounts more popular? EBRI found that of individuals who were offered an HSA but didn’t open one, one-third said they didn’t have the money to contribute, and 31% said they didn’t see the need. Others said it was too much trouble to open and/or manage the account, and that it was too complicated. One example: you have to save receipts for expenses you reimburse yourself for out of the HSA. “It’s the proverbial shoebox,” says Craig Rosenberg, a benefits consultant with AonHewitt in Norwalk, Conn. (Most plans give you an HSA debit card you can use to pay providers directly out of your HSA account, but that doesn’t work for say an out-of-network provider who demands immediate payment before you know what your out-of-pocket costs will be.)

Most employees are rolling over at least some dollars from year to year. EBRI found that the average HSA balance being rolled over increased from $592 in 2006 to $1,295 in 2009, and fell to $1,029 in 2010. The percentage of individuals without a rollover decreased from 23 percent in 2006 to 10 percent in 2009 and increased slightly to 13 percent in 2010. As the use of these accounts spreads, and the tax advantages become better understood, the percentage of individuals without a rollover should continue to decrease, and the dollar amounts being rolled over should grow. Goldsmith counts undercontributing to an HSA as one of the biggest mistakes employees make surrounding employee healthcare benefits.

To really max out healthcare-related tax-advantaged accounts, consider contributing to both an HSA and a flexible spending account or FSA. Most employers allow you to contribute $5,000 a year into an FSA (contributions will be limited to $2,500 a year starting Jan. 1, 2013). If you have an HSA, you can use your FSA only for vision and dental expenses. But the big catch with the FSA is that it’s a use it or lose it proposition: any money you don’t use in a given year is lost. With HSA money, that’s never a problem.