Are Health Savings Accounts the Cure?

Open enrollment for health care benefits has begun at many companies. If your employer lets you choose from a menu of health care plans, it's important to review your options carefully.

Medical costs keep going up. The average cost for a hypothetical family of four covered under an employer-sponsored preferred provider organization (PPO) plan is projected to rise to $31,065 for 2023, according to the Milliman Medical Index (MMI). The MMI estimates health care costs will grow by about 5.6% from 2022 to 2023, citing changing labor market conditions, provider shortages, supply chain issues and new price transparency requirements.

What can employees do to curb mounting health care costs? One possible solution is to use a tax-favored Health Savings Account (HSA). Although HSAs have been slow to catch on since their introduction in 2003, they're picking up momentum among tax-savvy employees. Two years after their inception, only 4% of eligible employees were enrolled in an HSA. At the end of 2022, $104 billion was held in 35.5 million accounts, up 6% for assets and 9% for accounts, respectively, from the prior year.

How It Works

An HSA operates like an IRA for medical expenses. In fact, it's sometimes referred to as a "Medical IRA." With an HSA, contributions are made to an account by the employee or, in some cases, by the employer (or both).

HSAs provides the following four tax advantages to employees:

1. Employee contributions within the prescribed limits are 100% deductible "above-the-line." This means you can write off the amount of your contributions whether you itemize or claim the standard deduction. The deduction also lowers your adjusted gross income (AGI) for other purposes. However, excess contributions are subject to a 6% excise tax and aren't tax-deductible. By comparison, unreimbursed medical expenses paid by an individual are deductible only if you itemize and the total exceeds 7.5% of your AGI. You can deduct only the excess above the 7.5%-of-AGI threshold, so most individuals don't qualify.
2. Any employer contributions made on behalf of an employee are excluded from tax. This is a valuable employee fringe benefit. And the employer can deduct its contributions.
3. Contributions to the account are invested and can grow without any current tax erosion, just like an IRA. This allows you to benefit from tax-deferred compounding.
4. Any distributions from the account used to pay for qualified medical expenses are tax exempt. This includes most physician and dentist visits, hospital stays, vision care, prescription drugs, co-payments, psychiatric treatments and other qualified medical expenses not covered by a health insurance plan. Note that drugs and medications other than insulin are treated as qualified medical expenses only if they're prescribed.

On the other hand, distributions from an HSA used to pay for nonqualified expenses are taxable at ordinary income tax rates, plus they're subject to a 20% tax penalty (recently increased from 10%). However, the penalty is eliminated after you've reached age 65.

Eligibility and Limitations

Federal tax law establishes certain eligibility requirements for HSAs. Specifically, the plan is available only if the individual:

• Participates in a high-deductible health plan (HDHP),
• Has no other health insurance coverage,
• Isn't enrolled in Medicare, and
• Can't be claimed as a dependent on someone else's tax return.

Note: Under current tax law, dependency exemptions are suspended through 2025.

The thresholds for HDHPs are indexed annually for inflation. For 2023, an HDHP is defined as a plan with a deductible of at least $1,500 and an out-of-pocket maximum of $7,500 for individual coverage. If an employee has family coverage, the deductible must be at least $3,000 with an out-of-pocket maximum of $15,000 for 2023.

For 2024, HDHP plans must have a deductible of at least $1,600 and an out-of-pocket maximum of $8,050 for individual coverage. If an employee has family coverage, the deductible must be at least $3,200 with an out-of-pocket maximum of $16,100 for 2024.

Furthermore, annual contributions to an HSA are limited, based on thresholds that are indexed for inflation. For 2023, the contribution thresholds are $3,850 for employees with individual coverage. If you have family coverage, the contribution limit is $7,750. In addition, a "catch-up contribution" of $1,000 is permitted for people over 55.

For 2024, the contribution limits will increase to $4,150 for employees with individual coverage and $8,300 for those with family coverage. The catch-up contribution amount will remain $1,000 for people over 55.

Once-in-a-Lifetime Opportunity

Generally, you owe tax at ordinary income tax rates if you receive a distribution from an IRA, plus a 10% penalty tax if you're under 59½, unless a special exception applies. But you might have an ace up your sleeve: You can roll over funds from an IRA to an HSA. The rollover is exempt from income tax, as well as the 10% penalty tax if you're under 59½.

An IRA-to-HSA conversion may be especially beneficial to someone who is nearing retirement or has already retired. The maximum amount that may be rolled over is limited to the maximum HSA contribution allowed for the year.

Important: You can only make the conversion from an IRA to an HSA once in your lifetime. Plus, the rollover is irrevocable, so there's no going back.

Other Special Considerations

HSAs are sometimes confused with flexible spending accounts (FSAs) for health care expenses. But health care FSAs are strictly employer-sponsored plans with a lower contribution limit and no HDHP requirement. The contribution limit for FSAs is $3,050 for 2023 and is projected to be $3,200 for 2024.

Also, the unused balance in a health care FSA at year end is forfeited under the "use-it-or-lose-it" rule. An employer may allow a 2½-month grace period or a carryover of $610 from 2023 to 2024. (It's projected to increase to $640 for carryovers from 2024 to 2025). In comparison, you can leave amounts in an HSA that can be used to pay for qualified expenses in the future. And the remainder keeps earning tax-deferred dollars.

An HSA is also portable. That means you can continue to use it if you switch jobs. The contributions in the account are fully vested so the money is yours to keep. But you can't continue making contributions if you no longer meet the HDHP requirement.

Finally, you can use an HSA if you're a self-employed individual. You don't have to be an employee for this purpose if you meet the eligibility requirements.

For More Information

Do you want to know more about HSAs? Your SSB tax and financial advisors can help you decide whether an HSA is right for your situation.

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