Q: How do HSAs work? Should I get one?
Geoff, Arlington VA
A: Health savings accounts are a relatively new kind of health insurance product. They combine a high deductible health plan (HDHP) with a tax-advantaged savings account (HSA). Unused money grows tax-free like an IRA, and neither contributions nor distributions are ever taxed if used for health care...
For more information on HSAs, please consult IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans.
An HSA combines two separate features: the HDHP and the HSA itself:
1. HDHP. A high-deductible health plan is one in which the insurance company doesn't pick up the tab for health care bills except in the event of a catastrophic, high-cost year (exceptions are normally made for preventive care, maternity, and well-child care).
The minimum deductible on an HDHP is $1100 for individuals and $2200 for families in 2008. In order to be HSA-qualified, the deductibles cannot be any higher than $5800 and $11,600, respectively.
As a result, most people will only need to use the insurance every few years, at most. The insurance companies will naturally charge a far lower premium to have the insurance. This generates a significant cash savings over traditional, first-dollar coverage--which brings us to the HSA.
2. HSAs. An HSA is a tax-advantaged savings account vehicle. Like a Traditional IRA, contributions are tax-deductible (or excluded from income if your employer makes the contribution). Like any IRA, the money grows tax-deferred. Like a Roth IRA, distributions are tax-free (assuming they are made for medical expenditures).
As you can see, the HSA is a powerful savings vehicle--tax free at both ends and in the middle.
The most that can be contributed to an HSA is the HSA dollar cap ($2900 for singles, $5800 for families). There is no limit to HSA fund accumulation. Money can be invested in anything an IRA can be invested in.
Where do people get the money to contribute to an HSA? For starters, they should deposit the premium savings from switching to an HDHP. If they wanted to, they could then continue to contribute up to the dollar cap. In many cases, the premium savings alone are sufficient to fully-fund or nearly fully-fund the HSA. In future years, there may be a lot of money in an HSA. People that year might want to pocket the premium savings.
If HSA money is used for a non-medical purpose, income tax and a 10% penalty must be paid on the distribution. Exceptions to this are made for death and disability. Medicare-eligible people don't need to pay the penalty for non-health use, but they must pay the income tax.
The main advantage to an HSA-qualified plan is that you get to stop paying very high insurance premiums to an insurance company. Instead, you pay low insurance premiums, and have a good deal of money left over. This money is best kept in an HSA to pay for medical expenses under the deductible and for retirement. Who wouldn't want to take money from an insurance company and put it in a savings account they own and control?
For more on this, try the following sources: