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Used properly, Health Savings Accounts are an incredible opportunity for you to save big on medical expenses, decrease your federal income taxes and increase your retirement savings (wow!). These accounts are allowed for people with High Deductible Health Plans, so if your plan carries an annual deductible of $1,200 for individual coverage or $2,400 for family coverage, you are eligible to open an account at one of many financial institutions now offering them.

The Stethoscope
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Health Savings Accounts (HSA’s) will allow you to save pre-tax dollars, and invest your savings to earn tax-free compound market returns,and, unlike Flexible Spending Accounts where you lose unused savings at the end of the year, HSA savings can be carried forward year after year. HSA’s do not need to be administered by your employer, so they’re easy to open and keep ownership of should you change employers.

More on Eligibility

HSA’s are designed to provide flexibility and control to W-2 employees who are enrolled in a high-deductible health plan (HDHP). In order to be eligible, you can’t be enrolled in another health plan or Medicare. Officers with more than a 2% share in an S Corp, self-employed people, and partners in an LLC or LLP are permitted only to make after-tax contributions, minimizing much of the benefit of the plans. However, for W-2 employees (yes, even if you are an employee of your own corporation) who have chosen a high deductible plan, these plans really can provide a significant benefit.

Contributions

In 2012, individuals can contribute up to $3,100 and families up to $6,250. There is a $1,000 additional contribution allowed if you are over 55 years of age. Contributions can be made all the way up to April 15th of the year following the target tax year, assuming you haven’t filed your taxes yet.

Taking Distributions

Tax-free distributions must be for qualified medical expenses, and can’t be to pay for anyone else’s expenses. Many institutions that offer HSA’s will also offer you a debit card so you can pay your medical provider directly.

Qualified Expenses

Note this is not an exhaustive list, for a complete list see IRS Pub 502.

• Fees charged by doctors, dentists, surgeons, chiropractors, psychologists, etc.
• COBRA premium payments
• Health insurance premiums
• Payments for prescription drugs and insulin
• Necessary travel expenses

Non-Qualified Expenses

Again, not an exhaustive list.

• Anyone else’s expenses, including a domestic partner
• Over-the-counter medications
• Health club memberships
• Cosmetic surgery

Once you turn 65, however, HSA dollars are locked into the plan, but it’s still not a bad deal! You will pay normal income taxes with no penalties on all distributions (so, at this point, the account acts just like an IRA).

To show you the huge potential impact of this strategy, here are a couple scenarios:

Sarah, a 35 year single female: Sarah saves $258.33 each month into her HSA for 30 years and earns an average annual 7% return. Her annual out-of-pocket qualified medical expenses rise linearly from $500 to $1,500 over the next 30 years.

Sarah’s total contributions to the Account: $92,999
Qualified Distributions: $27,500
Tax Free Earnings: $194,656
Account balance at age 65, when the HSA turns into an IRA: $315,155
Annual EXTRA taxable retirement income due to savings (assuming 25 year retirement): $27,043

Dave and Marcy,married with one child, both 30 years old: Dave and Marcy qualify to save more—$520.83 each month into their HSA, which is also invested and earns average annual 7% return. Their annual out-of-pocket qualified medical expenses rise linearly from $1,000 to $3,000 over the next 35 years (remember, it’s not likely that they’ll incur costs much higher than their deductible).

Contributions to the Account: $218,750
Distributions: $71,000
Tax Free Earnings: $648,229.27
Account balance at age 65, when the HSA turns into an IRA: $938,049
Annual EXTRA taxable retirement income due to savings (assuming 25 year retirement): $80,494

Pretty amazing, right? The key to achieving these kinds of impressive long-run results is to start as soon as possible and to select an HSA that allows you to invest in mutual funds, rather than just sits in cash.

Once the account is open, I recommend you choose a mix of low-cost index funds to invest your money.

Hilary is a personal finance expert, author, and fee-only financial planner in Silicon Valley, CA. Keep in touch with Hilary by subscribing to her Healthy Wealthy Families blog, for articles about healthy money practices, investing insights, and the psychology of money.

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