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Health Savings Accounts (HSAs) and Flexible Spending Arrangements (FSAs) are tools designed to manage the spending surrounding your healthcare needs. Both of these tools offer an opportunity to save money in anticipation of future medical expenses, and HSA funds can even be used to invest. Each is related to health insurance plans, but have differing characteristics in both their usage and tax implications. Read on for a breakdown and decide which option might best suit your needs.
Health Savings Accounts: How Do They Work?
HSAs are tied specifically to High Deductible Health Plans (HDHPs). In an HDHP, individual and family deductibles are high, usually higher than in other group insurance plans. In exchange for high deductibles, premiums are generally low. To offset the sting of the deductible amounts, users may set aside savings for certain medical expenses in an HSA. This funding, essentially a tax-favored savings account, can cover many medical expenses that fall outside of the deductible and allow for discretionary health care spending.
All HDHP plans are group insurance plans; they may be employer-sponsored or purchased on the open market. While the nature of HDHPs may change in response to the Affordable Care Act, the law on HSAs is expected to remain stable. HSA accounts exist independently of the plan; users may open accounts at banks, credit unions or other financial institutions that are qualified to be an HSA trustee. Though it’s not required, some employers contribute funds to employees’ accounts. HSA account holders contribute up to certain limits defined by the IRS. These funds may be withdrawn at any time for qualified medical expenses. Additionally, HSA trustees allow account holders to use the saved funds to invest in mutual funds, stocks or other investment vehicles.
Most contributions made by account holders are after-tax dollars, with the notable exception of a Section 125 Plan. This plan, sometimes called a cafeteria plan, is an employer-sponsored insurance option that allows participants to contribute pre-tax dollars to HSAs via paycheck deductions. If your contributions are made with after-tax dollars, all contributions are deductible, and any investment interest accrued is tax-free. Tax penalties only apply when accessing these funds for non-approved reasons.
What Are the Rules?
Allowable HSA contributions are set each year by the IRS. In 2013, individuals may accumulate a maximum of $3,250; families may save up to $6,450. HSA holders who are 55 and over are allowed an additional $1,000 as “catch-up” savings to offset higher anticipated expenses and boost account balances. The IRS also stipulates that deductibles must be no less than $1,200 for individuals and $2,400 for families. Out-of-pocket maximums are capped at $6,050 for individuals and $12,100 for families.
HSA accounts are only allowable for individuals who:
- Are a member of an HDHP
- Are not covered by any secondary health insurance
- Are not claimed as a dependent on another person’s tax return
- Are not entitled to Medicare
However, withdrawals for medical expenses may be used for other family members. You, your spouse and any dependents who do not file a joint tax return or earn an annual gross income in excess of $3,800 may use these funds for qualified medical expenses.
Qualified medical expenses are defined by the IRS as expenses that alleviate or prevent a physical or mental illness or its adverse effects. Generally, covered expenses include dental care, vision care, prescribed medication (with the exception of insulin), long-term care insurance premiums, COBRA coverage, health care premiums if you are receiving unemployment and Medicare/Medigap premiums if you are over 64. All qualifying expenses must be incurred after you open your HSA.
withdrawals for medical expenses may be used for other family members. You, your spouse and any dependents who do not file a joint tax return or earn an annual gross income in excess of $3,800 may use these funds for qualified medical expenses
Examples of covered expenses include:
- Bandage supplies
- Drug or alcohol abuse treatment
- Braille reading material
- Breast Pumps
- Service Animals
- Lab Fees
- Hearing Aids
- Fertility treatments
- Home health care
The complete list of eligible and ineligible expenses is exhaustive; check it in order to better determine whether an HSA is right for your family. Some alternative care practices, such as acupuncture and chiropractic procedures, are also covered by health savings accounts.
Is an HDHP with an HSA Right for Me?
The advantage of low monthly premiums and the opportunity to earn investment income without a tax penalty is appealing for many families. Employees who receive company contributions to HSAs are in an even better position to take advantage of this, though fewer companies offer this benefit in a struggling economy. For young and healthy families, this option can help them to obtain low-cost insurance, to reduce out-of-pocket costs and to earn a little income on the side.
However, older families or families with chronically ill individuals should take into account the need to withdraw from an HSA. The tax benefits still apply, but if the funds are being used on a regular basis, there is less opportunity to use an HSA to invest. As you evaluate this option for your family, consider each member’s health and the plan’s maximum out-of-pocket cost to determine whether you could potentially save money.
Flexible Spending Arrangements
Flexible Spending Arrangements are savings plans that deduct pre-tax contributions from your paycheck – contributions that specifically cover qualified out-of-pocket medical expenses. FSAs are affiliated with employer-sponsored group plans only; employers may or may not choose to contribute to employees’ FSAs. Since all contributions are pre-tax, you can save a considerable amount on expenses as they add up.
Unlike HSAs, there are no tax implications to these accounts. At the beginning of the year you specify an amount you’d like to save. There is currently no legal limit to the percentage of your earnings that can be deferred to an FSA, though this amount will be capped at $2,500 in 2013. FSAs and HSAs distribute funds similarly; a common method is to provide a debit card to be used to access these funds. FSAs dictate that all funds be used expressly for qualified medical expenses; there is no opportunity to invest.
The advantage to an FSA is that once established, the money may be used in advance of paycheck deductions. For example, you elect to defer $3,500 annually to your FSA beginning in January…you may access any or all of the $3,500 that you plan to defer, even though you have not yet technically earned that money
The advantage to an FSA is that once established, the money may be used in advance of paycheck deductions. For example, you elect to defer $3,500 annually to your FSA beginning in January. If you need new glasses or dental work in February, you may access any or all of the $3,500 that you plan to defer, even though you have not yet technically earned that money. You, your spouse and your dependents may all use these funds to offset out-of-pocket healthcare costs.
FSAs do carry some restrictions.
Qualifying medical expenses are tied to the company-sponsored health plan and therefore may vary from plan to plan. Generally these expenses are limited to dental and vision care, prescription medication and other preventive and treatment expenses as defined for HSAs; FSA funds cannot be put toward: premiums for long-term care insurance, Medicare payments, COBRA or any other health insurance premiums. No over-the-counter medications are considered qualified expenses.
FSAs also carry a “use it or lose it” clause. Employees must estimate the amount of out-of-pocket expenses they expect to incur during the next year. If those funds are not used by the end of the plan year, the money is forfeited. Some FSAs do allow a grace period of up to 2.5 months into the next plan year, but your company is not required to offer it.
FSAs also carry a “use it or lose it” clause…If those funds are not used by the end of the plan year, the money is forfeited
How do HSAs Stack Up Against Roth IRAs or 401(k) Investments?
Most financial institutions set a required minimum amount, typically $2,000, that must be saved in an HSA before you can invest. While money from another HSA may be rolled into another qualified HSA, it is not possible to transfer funds from a retirement account into an HSA. However, there is no reason you can’t have both. While your potential return on HSA-funded investments has been limited by healthcare reform and the resultant caps on HSA savings, the tax-free nature of this investing tool is hard to ignore.
How Do I Open an HSA Account?
If you are a member of any HDHP health insurance plan, you may go to financial institutions who act as HSA trustees to open your account. Shop around several vendors before you choose one; each one will have its own fee structure and investment choices. Use payment calculators to compare and contrast your options. If you plan to use your HSA funds versus investing them, choose a vendor that offers easy access to those funds, such as via debit card or electronic account transfer.
If you are an older individual, special considerations may apply to you. You must designate a beneficiary, usually a spouse, for your HSA funds. In the event of your death, your spouse becomes the owner of the HSA and may continue to use it as such. Should you not designate a beneficiary, some plans will automatically consider your spouse a beneficiary but the funds no longer operate as an HSA and become taxable. Other plans will default the funds to your estate, in which case the accrued total is also subject to income tax.
Be sure to keep up to date on all Affordable Care Act changes at the official site: HealthCare.gov.