Health Savings Account (HSA): The Medical IRA
(Updated December 2021 to reflect new 2022 rates)
Every year in late November, early December, you are presented with the opportunity to re-evaluate your existing health insurance and compare it to what else is out there. You may find due to changes in rates, members in your family, a move, etc., that there is something better out there than what you currently have.
This paper is not necessarily to discuss the different plan options out there, but rather to discuss a savings/investment vehicle that is tied to a particular type of health insurance: The Health Savings Account. It is pretty rare to find a government employee familiar with the Health Savings Account; in fact, most confuse it with the FSA-the Flexible Spending Account. They are different animals, as we will see, with the HSA offering a much better benefit.
What is a Health Savings Account?
OPM defines an HSA as, “an account that you own for the purpose of paying qualified medical expenses for yourself, your spouse, and your dependents”. Basically, it is a savings account. You contribute to it, the insurance company itself contributes to it (yes, we’ll get to that in a minute), and you pay medical expenses from it. In some ways, if you are familiar with the FSA, it may help you understand the HSA. Every pay period, you elect to contribute some money into the account that is only to be used for medical expenses. The money stays in there and grows, and typically you get some tax benefit on the front end (the contribution), which is why you do it in the first place. This is similar to the FSA, but this is where the similarities end.
How does it work?
Unlike the FSA, with its use-it-or-lose-it rules, your money ALWAYS stays in the HSA and continues to grow. Whatever balance you have at the end of the year stays in the account and carries over the next year. And the next year. And so on. With no maximum account balance limit.
In addition to your contributions, many HSAs also have insurance companies that agree to contribute as well. For example, Aetna contributes $1,600 a year to the HSA if you are on their Self and Family plan. That money also does not go away—it continues to grow year after year, assuming I don’t spend the money on medical expenses, of course.
Theoretically, an individual could build up $100,000 in his HSA over a 15-year period, something completely impossible with an FSA. Whenever the HSA owner has a medical expense, he pays the expense directly out of the HSA with the supplied debit card. There are no receipts to submit for reimbursement. So, it really does work like a typical savings account, but with limitations on what you can use the money for—in this case, just medical expenses.
Are there tax benefits?
Yes, as I mentioned earlier, all contributions are tax deductible. This means, the contributions lower your annual income for the year. Assume you make $100,000 and you contribute $5,000 to your HSA, you will only be taxed on the $95,000. This functions identically to your TSP. Contributions made to your Traditional TSP reduce your taxable income for the year. Also like your TSP, earnings on the money in the HSA account grow tax-free. In other words, whatever interest or capital gains you make in your HSA for the year are not taxed. This is why the HSA is sometimes referred to as a Medical IRA. However, unlike the Traditional TSP which taxes the distributions when you finally take the money out, the HSA money is NEVER taxed, assuming it is used to pay medical expenses.
So, in that sense, it’s an incredible tax-savings vehicle. Not only do you get a tax benefit up front, you don’t pay taxes on the contributions or the gains when you withdraw them for your medical bills. I think you can quickly see how this can figure into someone’s tax strategy for the year. Let’s walk through an example.
Jack and Jill are married and household salary is $180,000. Jack contributes the maximum to his TSP ($20,500 for 2022), and the maximum to his HSA (yes, there is a maximum, not surprisingly), which is $7,300 for 2022. Jack and Jill’s taxable income for the year has just been reduced from $180,000 to $152,200 by contributing to tax-deferred (TSP), and tax- free (HSA) accounts. That’s a substantial savings immediately. (If the insurance company contributes to the HSA, that also counts toward the overall limit. If this is the case, the contribution limit for the individual is the $7,300 minus whatever the insurance company contributes).
When either Jack or Jill have medical expenses for 2022, they simply use the debit card to pay for the bill. Assume a bill is $100. Because they are using money to pay this expense that has never been taxed, they are paying with pre-tax dollars. You may have heard that term before. Any time you can, you want to pay bills (or anything else for that matter) with pre-tax dollars. It reduces the overall cost. You only have to earn $100 pre-tax to pay a $100 bill. If you are using after-tax money, will $100 in earnings pay a $100 bill? No, of course not. To take home $100 to pay the bill, you will need to earn $125 or more, to still have $100 left after taxes to satisfy the bill.
What this means for Jack and Jill is in effect that the $100 bill is only really costing them $76 (assuming they are in the 24% tax bracket).
So, in summary, the tax benefits are this: 1. Tax deductible contributions lower your income tax. 2. Gains and contributions grow tax free. 3. Withdrawals for medical expenses are also not taxed, in effect creating a discount for all medical expenses.
How does the money “grow” while it is in the account?
Depending on the HSA you go with, you have the choice between several different investments within the account. Just like you have choices in your TSP between say, the ultra-safe G Fund and the more aggressive I Fund, you have similar investment options in your HSA as well. For example, in the Aetna HSA, in addition to having the option of just keeping the money in cash, earning a savings account rate, there are 24 different mutual funds to invest in. They run from safe government bond funds to many different types of stock funds. There are even target funds, very similar to the TSP Lifecycle Funds, where a particular year is chosen and the investments automatically rebalance the closer one gets to that year. Just a few of the actual funds available are: Dodge & Cox Income Fund, Oppenheimer Main Street Small & Mid-Cap Fund, American Funds (through 2055) Target Date Retirement, and Vanguard Dividend Appreciation Index Investor. In short, there are plenty of options to choose from with what to do with your balance.
Obviously, like with any other investment, if you are anticipating needing the money soon, do not put it in something with a risk level you cannot tolerate. If you know your daughter needs braces later this year, putting the entire balance in an international stock fund probably isn’t the wisest choice.
What medical expenses can I use the money for?
As with any tax savings vehicle, the IRS has specific rules in place to ensure the benefits are not abused. In the case of an HSA, they limit the amount of annual contributions, and what the money can be used for. “Qualified” medical expenses mean pretty much what you think it means: most medical, dental and vision services, as well as prescription drugs. In essence—it has to be medically related. Don’t think you’ve found a way to pay your mortgage with untaxed money. But, in addition to standard medical expenses, there are some other bills the IRS allows you to pay out of your HSA: Medicare Part B premiums, Long-term care insurance premiums, and health insurance premiums—if you are getting unemployment compensation. So, it’s a little broader than simply medical expenses. Under the new CARES Act of 2020, the HSAs are now allowed to pay for over the counter medication, i.e. non-prescription meds.
Are there any other benefits?
Depending on how the HSA is set up, the insurance company will often times contribute to your HSA. I receive $150 a month deposited into my account from the insurance company. This money becomes mine immediately. There is no vesting period required. This is also automatic- there is no matching requirement. The downside, if there is one (how can free money have a downside?), is that this $1,800 goes against my $7,300 contribution limit for the year. This means I can only contribute $5,500 to the HSA myself, and I only receive the tax break on the $5,500. I don’t get to claim a tax deduction on the $1,800 from the insurance company. Still, it’s $1,800 added to the value of my account.
While this may not be true for everyone, I saw my FEHB premiums go down when I switched to Aetna from Blue Cross/Blue Shield. The switch saved me approximately $15 a pay period. Obviously this is very situational dependent on your current plan, where you live, the plan you switch to, etc. But, for me it resulted in an annual $390 premium savings.
So, how do I set one up and are there any downsides? It sounds too good to be true.
I’ve lumped those two questions together since the way it is set up and the downsides (if one sees it as such) are basically related to the underlying vehicle that allows you to have an HSA—the High Deductible Health Plan (HDHP). Nothing is free in this world except bad advice and a mother’s love. And any IRS-governed product is no exception.
You can’t always just set up an HSA account at your local bank or brokerage, it must be done through a special custodian that the IRS approves to manage it. While this may be done at some banks, insurance companies, or other financial institution, for our purposes, probably the most practical is to do it in conjunction with the health insurance company, who sets it up for you when you go with their HDHP, assuming you request it.
Here’s where the first downside appears: You probably have to change your health insurance plan. For example, if you have the standard Blue Cross/Blue Shield plan, it is not a HDHP, which means you can’t have an HSA. Which leads to the next obvious question....
What exactly is meant by a High Deductible Health Plan?
An HDHP is a health plan that has--get this--a high deductible. Government employees are literally the world’s worst at creative names.
For the purposes of an HDHP, the deductible minimum is set by the government, not the insurance company. Remember, this whole plan is tightly regulated so the government gets way into the insurance company’s business here. The government establishes guidelines and then the insurance company is required to work within those guidelines. They have leeway, but only within the boundaries the government sets.
To be considered a HDHP, the insurance company must have a minimum annual deductible of not less than $1,400 for self-only coverage, or $2,800 for family coverage. (Family coverage also includes self+1). The maximum deductible within an HDHP (remember the government sets both the minimum and maximum) is $7,050 for self-only and $14,100 for family. (These are 2022 limits, subject to change each year). Again, those are the boundaries; the insurance company is free to set its limits anywhere it wishes within those limits. We will get into a specific example later, using actual, real-world numbers. And just for clarification, these deductibles do not include premiums. Premiums never count toward deductibles in any plan that I am aware of.
These deductibles may elicit some sticker shock if you’re used to meeting one much lower. There are some characteristics of some plans that help to soften this blow, however. One is that the deductible does not have to be reached before the plan pays for preventative care. Just like non-HDHP plans, the insurance company may provide 2 free teeth cleanings a year, or $100 towards a pair of glasses, free routine eye exams, or a co-pay for a physical, for example.
Another one is that many insurance companies contribute to your HSA for you if you set one up. (And really, I don’t know why anyone would have an HDHP and NOT have an HSA with it). For example, Aetna contributes $1,600 annually, as I mentioned earlier. This helps offset the deductible. (My new insurance contributes even more—read on.)
A third blow softener is that HDHP plan premiums may be less than traditional plan premiums. My premiums when I switched from Blue Cross to Aetna went down about $15 per pay period. That may not be a substantial savings but it’s almost $400 that I can either add to the HSA or just set aside to help pay my deductible for that year.
2021 UPDATE: Aetna is now more expensive than the Blue Cross plan I had when I switched in 2015, and I have switched again to GEHA for 2021. See example below.
2022 UPDATE: Still with GEHA as it is almost $100 a pay period cheaper than Aetna for 2022 and almost $150 a pay period cheaper than BCBS.
Any more downsides?
This may or may not be applicable for you, but I include it because insurance is such a personal, situation- specific item. Change one detail and it vastly changes the plan that’s right for you. So, with that in mind, government regulations state that if you have an HSA, you cannot also have an FSA. At least, in general. You are permitted to have what is termed a Limited Expense Health Care Flexible Spending Account (LEXHCFSA). And yes, that is the official acronym. This FSA only allows dental and vision care services. I know many people have FSAs set up simply for their known vision expenses such as glasses or contacts. This is still permitted in conjunction with an HSA. Also a dependent care (DCFSA) is allowed as well. Some of you pay daycare expenses through that. It is my understanding this type of FSA is still permitted with an HSA.
Once you are on Medicare, you may not contribute any more to the HSA. You can still use the money— remember the money never expires—you just cannot contribute any more to it.
Are there any consequences to using the money for expenses other than medical?
Yes. Just like most IRA’s, including the education kind, if you take the money out for other than qualified medical expenses, you are subject to taxes on the money. This is pretty standard for tax-deductible accounts. Furthermore, if you take the money out for non-medical expenses AND you’re under the age of 65, you will also be hit with a 20% penalty. This works similarly to when you take an IRA distribution prior to reaching 59 1⁄2. Or if you take a TSP withdrawal earlier than when you’re eligible.
Basically, what the IRS is saying is that this account is for you to save for potential medical expenses down the road. Try to use it for something other than that and they’ll make things very uncomfortable for you. But, on the other hand, if you have some terrible emergency and you absolutely, positively need the money, you can get to it. It’s not like it’s lost forever, you’ll just be penalized.
My Example (updated for 2021)
I’ve been promising to do this, so let’s get to my specific example. It may help clear up some things. During the FEHB Open Season of 2015, my wife and I switched from Blue Cross to Aetna HealthFund HDHP with HSA. My premiums went from $148.46 to $132.43. We were able to keep all of our own doctors (that would’ve been a deal killer with my wife). Remember the minimum deductible for an HDHP is $2,800. Aetna’s was just slightly over that at $3,000. After $3,000, Aetna paid 90% of the medical bills and we paid 10%. The maximum out of pocket for our plan in one year was $10,000 (and only $6,850 if you remain in-network). After that, Aetna paid 100%.
Immediately upon switching, we set up the HSA through Aetna and Aetna began contributing $125 monthly to our account. The effect of this contribution from Aetna means that although our deductible is $3,000, Aetna was actually giving us $1,500 a year that we can use immediately to help meet that deductible. Once it all nets out, our deductible really ends up being $1,500 a year before we are at the 10% threshold. This goes into an account that has a MasterCard debit card associated with it, so paying medical bills are painless. Well, not painless, but at least easy, logistically speaking.
Dental cleanings and x-rays are free at our dentists, free physicals and mammograms once a year, and each plan member receives $100 every two years for glasses or contacts, but none of us need glasses...yet. There are many other benefits that are too long for me to elaborate on.
*******************************************************
December 2020 Update: During this most recent (2020) open season, we again switched FEHB insurance. Here’s why. While Aetna’s premiums were cheaper than Blue Cross in 2015, they have increased substantially every year. For 2021, they were raised yet again to $237.98 per pay period. That is a 60% increase in just 5 years. 60%!! No thank you. We have stuck with an HDHP/HSA but we went with a different carrier: GEHA. Here are some of the benefits of switching:
GEHA premiums are $159.04 biweekly. This is about $80 a pay period in savings, or a little over $2,000 for the year.
GEHA contributes more to my HSA. Aetna contributes $1,600 a year, GEHA contributes $1,800 a year.
We keep our same doctors and network.
The deductible is smaller. $3,000 vs Aetna’s $3,600.
Copays are less for doctor visit. 5% vs Aetna’s 15%
I’ve calculated I will save approximately $3,000 in 2021 by switching from Aetna to GEHA.
This works great for our particular situation. We are on no medication, we are very healthy, and we are in an upper tax bracket so the tax benefits of HSA contributions work out wonderfully for us. We hope to enter retirement with a rather substantial balance in the HSA that, if invested wisely, will serve us well in our later years. It is not unrealistic for our account to be six figures when we reach Medicare eligibility age. That is an extra buffer of medical expenses, and let’s face it, that’s probably the largest expense as we age.
2022 UPDATE:
GEHA HDHP Self and Family is $167 a pay period vs Aetna HDHP $265 a pay period vs Blue Cross Blue Shield Standard Family $314. That’s a savings of $2,600 or $3,800 a year, depending on what you’re comparing it to. (GEHA vs Aetna, or GEHA vs BCBS).
GEHA contributes $1,800 to HSA, Aetna contributes $1,600 to HSA, BCBS contribute $0 to an HSA (HSA is not allowed). So $200 more for GEHA vs Aetna.
By maxing out HSA contributions of $5,500 a year ($7,300 max - $1,800 that GEHA contributes), I save myself $1,320 in taxes (24% bracket).
Total annual 2022 savings: Roughly $6,900 (GEHA vs BCBS)