Health Savings Account: What is it and is it Right for You?

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Credit Sesame discusses whether a health savings account is the right choice for you.

Americans have an important financial choice to make at this time of year. It is open enrollment period for health insurance plans.

What is open enrollment?

Open enrollment is a period in late fall when individuals can sign up or change their health insurance without a qualifying event such as getting married, having a baby or losing other health coverage. During this period, you can change to plans that cover even pre-existing conditions. In 2022, the open enrollment period runs from November 1 through January 15, 2023; although some states and employers have different periods. You can see plans and prices on the government marketplace or some states have their own health exchanges, currently including:

  • California
  • Colorado
  • Connecticut
  • Idaho
  • Kentucky
  • Maine
  • Maryland
  • Massachusetts
  • Minnesota
  • Nevada
  • New Jersey
  • New Mexico
  • New York
  • Pennsylvania
  • Rhode Island
  • Vermont
  • Washington DC
  • Washington

What is a health savings account?

According to the Internal Revenue Service, an HSA is a tax-exempt account that can be used for medical expenses.

The tax exemption applies in three ways:

  1. Contributions you make to an HSA can be deducted from your taxable income. This is true even if you don’t itemize deductions on your tax returns.
  2. Investment earnings on the money in an HSA is tax-exempt.
  3. You don’t pay taxes when you take money out of an HSA, as long as you use it for qualified medical expenses.

A health savings account (HSA) may allow you to handle your medical expenses more efficiently. In addition to helping to pay for near-term medical costs, an HSA can also be a tool for building long-term wealth. Because of that hidden superpower, HSAs aren’t just for people who are concerned about high medical expenses. In fact, they may be suited to people who don’t anticipate spending much on health care in the year ahead. An HSA can do double duty by helping you manage upcoming medical expenses and build long-term wealth.

To put money into an HSA, you have to be actively participating in a high-deductible health plan (HDHP). An HDHP is a type of health insurance plan with a higher deductible than most health insurance plans. In December 2022, that deductible is around $1,400 for individuals and $2,800 for family plans. If you do not have an HDHP, open enrollment is the time to sign up for one and take advantage, if desired, of a health savings account.

How to benefit from a health savings account

There are two ways you may benefit from having an HSA:

  1. In the near-term with an HDHP.
  2. In the long-term as a saving vehicle.

Health savings account and HDHP

High-deductible health insurance means you risk having high out-of-pocket costs if you need health care during the year.

An HSA helps you set some money aside to pay those out-of-pocket expenses. This even includes over-the-counter medication. You can also use money in the HSA towards paying your health insurance premiums.

This approach might be appealing if you don’t typically have a lot of medical expenses from year to year. It’s still important to have health care coverage in case something unexpected happens. An HDHP allows you to get that coverage while paying lower premiums than you would for a health insurance plan with lower deductibles.

HSA wealth building for future medical expenses

An important feature of HSAs is that it is not use-it-or-lost-it. You can typically roll the money in an HSA over from year to year.

If you have a healthy year with little or no out-of-pocket medical expenses, you can keep funds in your HSA for future expenses. You can even invest the funds so they grow within the account.

Currently, annual HSA contributions appear to be limited to $3,650 for an individual and $7,300 for families. However, this can add up over time and give you a nest egg for paying future medical expenses.

According to data from the Bureau of Labor Statistics, health care costs represent just 5.3% of spending for people aged 25 to 34. However, for people aged 65 and over, this jumps to 13.5%. Accumulating money in an HSA can help you meet those rising health care costs.

Advantages of a Health Savings Account

Since you are bound to encounter health care costs at some point, money in an HSA can be more valuable than other retirement savings for three reasons:

  1. No tax on the way in or out of the plan. With retirement plans like a 401(k) or IRA, money is taxed either on its way into or out of the plan. With an HSA, contributions are deductible and distributions are tax-exempt as long as they are used for eligible medical expenses.
  2. No age restrictions on when you can take money out. With retirement plans, there are restrictions on how soon you can take money out. If you take money out early, you face a 10% penalty on top of any ordinary tax consequences. Money in an HSA can be taken out at any time, providing it is used for eligible medical expenses.
  3. Opportunity for additional contributions beyond retirement plan limits. HSA contributions can supplement your retirement savings. There is an annual dollar limit to how much you can contribute to a 401(k) or IRA. Putting money into an HSA can allow you to get additional tax benefits over and above retirement plan contribution limits.

Balancing health savings with other savings

You can have an HSA and other savings accounts and just need to figure out how much to save in each.

Emergency savings

It’s good to have some money set aside in an ordinary deposit account for meeting unexpected expenses. To get this kind of financial cushion, you should build an emergency fund before putting money in an HSA. However, emergency expenses are often used for unexpected medical bills. So you can think of an HSA as part of your emergency savings.

401(k)/retirement savings

HSAs have tax advantages over retirement accounts but are limited to use for medical expenses. So, it may make sense to have both an HSA and a retirement account.

If you participate in an employer-sponsored retirement account that makes matching contributions. You will likely get the most bang for your buck by contributing enough to the retirement plan to get the maximum employer match. After that, you could direct additional savings into an HSA. This helps you prepare for future health care costs and gives you better long-term tax advantages. The contribution limit for HSAs is relatively small, so if you reach the ceiling and can still save more, add that excess to your retirement account.

A Health Savings Account has uses beyond the coming year’s medical expenses. Used in conjunction with a high deductible health plan, it can help you cover both near-term and long-term health care costs.

With open enrollment season for many health plans running out soon, consider adding an HSA and an HDHP to your December shopping list.

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Disclaimer: The article and information provided here is for informational purposes only and is not intended as a substitute for professional advice.

Richard Barrington
Financial analyst for Credit Sesame, Richard Barrington earned his Chartered Financial Analyst designation and worked for over thirty years in the financial industry. He graduated from St. John Fisher College and joined Manning & Napier Advisors. He worked his way up to become head of marketing and client service, an owner of the firm and a member of its governing executive committee. He left the investment business in 2006 to become a financial analyst and commentator with a focus on the impact of the economy on personal finances. In that role he has appeared on Fox Business News and NPR, and has been quoted by the Wall Street Journal, the New York Times, USA Today, CNBC and many other publications.

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