Since health savings accounts (HSAs) were introduced in 2004 as part of the Medicare Prescription Drug, Improvement and Modernization Act, they have surged in popularity as a flexible way for numerous Americans to reduce taxable income and save for future medical expenses. But since the IRS establishes new rules governing HSAs each year, it’s important to understand how these accounts work and determine whether you qualify before enrolling.
What is an HSA and how does it work?
An HSA is a personal savings account that allows you to pay for qualified medical expenses with pre-tax dollars. Whether you fund an HSA directly or the money is deducted from your paycheck via an arrangement with your employer, you do not have to pay income tax on the funds that you contribute to your HSA. In addition to lowering your federal income taxes, all states, with the exception of California, New Jersey, and Alabama, offer tax incentives for contributing to an HSA. Deposits and withdrawals from your account are reported on IRS Form 8889.
You can take tax-free withdrawals of your HSA funds at any time to pay for your own unreimbursed medical expenses or those of any other family members who are part of your tax household, such as your spouse or dependent children. The IRS allows HSA funds to be used for a wide range of medical expenses, including co-pays for doctors’ appointments, vision and dental care, out-of-pocket costs for various procedures, certain over-the-counter medicines, and even acupuncture or chiropractic services. While the list of qualified medical costs is extensive, HSA withdrawals used for anything else are subject to income tax and a 20% penalty. The rules change, however, once you reach age 65: the penalty no longer applies, but withdrawals used for non-medical expenses will still be subject to income tax. In addition, you can no longer contribute to your HSA if you are enrolled in Medicare, but you can continue to take tax-free withdrawals for qualified medical expenses—including Medicare premiums.
Unused funds left in your HSA will roll over from year to year. Since the account grows tax-free—and many providers allow you to invest the money—HSAs also serve as valuable tools for saving for retirement. If you are not planning to use your HSA funds for imminent medical expenses and would prefer to treat your account as a retirement savings vehicle, be sure to research different HSA providers to determine which ones offer the best fees, interest rates, and investment options to suit your goals.
Qualifying for an HSA
To enroll in an HSA, you must be covered by an HSA-qualified high-deductible health plan (HDHP). In 2020 and 2021, these plans must have deductibles that are no less than $1,400 for singles and $2,800 for families. Additionally, HDHPs must have a maximum allowable out-of-pocket limit of $7,000 for singles and $14,000 for families. These plans may only cover preventive care before the deductible is met, although the IRS is currently allowing HSA-qualified HDHPs to pay for testing and treatment of COVID-19 prior to meeting the deductible.
HSA contribution limits for 2020
The annual contribution limits for HSAs generally increase each year. For 2020, you may contribute up to $3,550 if your HDHP only covers yourself, and $7,100 if you have family coverage. In 2021, these amounts will increase to $3,600 and $7,200 respectively. However, if you are age 55 or older, you may contribute an additional $1,000 to your HSA each year.
If you have a qualified high-deductible health plan, an HSA may serve as a valuable tool for reducing your tax burden, funding current and future medical expenses, saving for retirement, and granting you more autonomy in deciding how to spend your healthcare dollars. To learn more, contact the Tax Diversification team today!
–Stephanie Vance, J.D.
(Sources: https://money.usnews.com/money/retirement/articles/how-to-use-an-hsa-to-save-for-retirement, https://www.healthinsurance.org/faqs/how-does-a-health-savings-account-hsa-work/).
We are Arbor Wealth Management, a Phoenix-based firm that offers comprehensive financial planning services. We’re partners in your financial future. Like a conductor coordinating a beautiful symphony, we’re intimately involved in your financial future. We take the time to know how each instrument in your personal orchestra is performing, keeping all aspects of your plan in tune. We accomplish this by making sure your finances remain pliable, whether you are in an accumulation or distribution stage in life.
Leave A Comment