By William G. (Bill) Stuart
Director of Strategy and Compliance
Benefit Strategies LLC
July 28, 2016
From their inception as part of the Medicare Prescription Drug, Improvement and Modernization Act of 2003, Health Savings Accounts, or HSAs, have provided a unique opportunity for average Americans to pay their increasing out-of-pocket costs for medical care more effectively. HSAs are unlike other health care reimbursement accounts in the flexibility, convenience, time horizon and permanence that they represent.
Individuals must be HSA-eligible to open and contribute to an HSA. They must follow certain rules around contributions and distributions. And they face certain tax filing requirements to report their activity annually to both the federal government and authorities in their state of residence. In this space, we review many of these rules and requirements regularly, so continue reading (and review past articles here).
Let’s take a look at 10 great reasons to own an HSA:
- HSAs aren’t just tax-advantaged – they’re tax-perfect
HSAs are the only savings vehicle available to ordinary Americans that offer pre-tax or tax-deductible contributions, tax-free growth of principal and tax-free distributions for eligible expenses. All other tax-favored accounts have either taxable contributions [Roth Individual Retirement Arrangement, or IRA and, Roth 401(k)] or taxable distributions [traditional IRA and traditional 401(k)]. HSAs’ tax advantages are unmatched.
2. HSAs are a portable financial asset
While employers typically limit their relationship to a single HSA administrator (thus all but requiring you to open an account with that company), your HSA isn’t tied to your employer. Rather, it’s a trust and a personal financial asset that you own, manage and control. When you leave employment, your HSA remains your personal financial asset – you don’t need to roll it over to an individual HSA (though you may want to roll over the balance into an HSA with a different HSA administrator that you choose (or a future employer chooses) and you don’t lose any of your balance as a result of leaving employment or losing your eligibility to continue funding your HSA.
3. Owners can participate
The Internal Revenue Code, or IRC, places restriction on owners of certain entities: members of a Limited Liability Company, or LLC; partners in a partnership; and 2% or greater owners of Subchapter S corporations. These owners can’t, for example, make elections to a Health FSA. By contrast, they can participate in an HSA program, though they can’t receive a tax-free contribution from the company (it’ll be taxed as ordinary income when they receive any such contribution) and can’t make pre-tax contributions through a Section 125 or Cafeteria Plan (though they can contribute after-tax dollars and deduct the contributions on their personal income tax return). Once they overcome these restrictions on contributions, they can manage and enjoy the tax advantages of their HSAs just as their employees can.
4. HSA balances are nonforfeitable
Individuals who’ve elected to participate in Health FSAs in the past are familiar with the use-it-or-lose-it rule. Although several recent changes to Health FSAs reduce the risk of forfeiture, any money that employees contribute to Health FSAs that aren’t spent by the end of a defined benefit period revert to the employer. Health FSA participants often make a mad dash to the optometrist (and used to sprint to the pharmacy when over-the-counter drugs and medicine were eligible items without a prescription) to ensure that they spent their entire balance before forfeiting any money. This isn’t to say that Health FSAs are bad. Participants enjoy the same short-term tax advantages as HSA owners, but they face the possibility of forfeiture if their election is greater than their actual expenses.
By contrast, HSAs are a personal financial asset without a use-it-or-lose-it provision. Any funds not spent in a given year remain in the account for future use – whether during the next year or decades later. Thus, HSA owners don’t need to worry about overfunding their accounts (an exercise that typically leads to conservative underfunding and a corresponding loss of tax benefits by Health FSA participants) or scrambling to buy a fourth pair of prescription sunglasses just to exhaust their balances before the end of the plan year. In fact, there is no plan year with an HSA itself. An HSA is an open-ended fund, and balances roll forward and are always available to spend in the future.
Think about the possibilities here. We touch on this topic again below and will talk more about this topic in a future column. For now, just imagine how you can integrate an HSA into your retirement planning strategy. You can fund an IRA or 401(k) to cover non-medical retirement costs (distributions taxed as ordinary income) and fund your HSA to reimburse medical expenses in retirement (distributions not taxed).
5. HSA owners can adjust their contributions during the year
One of the limitations of Health FSAs is that participants face a very important financial decision when determining how much of their salary to direct into the Health FSA. They can’t adjust their election during the year (except for certain life events like birth, adoption, marriage and divorce), so they need to balance not overcontributing (thus facing possible forfeiture) or undercontributing (thus losing potential tax advantages).
By contrast, HSA owners can make prospective adjustments to their pre-tax payroll or personal contributions at any time (though employers can place reasonable limits on the frequency). They can increase contributions as they incur additional expenses or reduce contributions once they’ve deposited enough to cover anticipated expenses. They can make single or multiple lump-sum contributions to match their income flow (perhaps a large commission payout or annual bonus), or they can contribute for the first eight months of the year and then stop contributing to free up funds for holiday shopping. HSA owners have a degree of flexibility that ensures that they can maximize the tax advantages associated with their accounts. They can also make personal post-tax contributions (deductible when they file their personal income tax returns) outside the payroll system to make lump-sum contributions on their own schedule.
6. Accountholders can build their balances with investments
Your HSA is a financial asset that you control. Most HSA cash balances are placed in FDIC-insured cash accounts. You also have the ability to invest – typically through a menu of up to four dozen no-load mutual funds. Different administrators have very different minimum balances needed to invest, investment options, services and fees, so be sure to review your administrator’s (or prospective administrator’s) investment program.
Benefit Strategies offers 21 funds through our partnership with Healthcare Bank, an institution focused exclusively on health care savings programs. For a list of the funds, click here.
7. HSA owners face no reimbursement deadlines
Health FSA participants typically scramble about two months after the end of their plan year to organize and submit their receipts for eligible expenses to meet the reimbursement deadline. This activity can prove stressful – especially when they realize that they’ve lost a receipt or didn’t spend as much as they elected.
By contrast, HSA owners direct their own reimbursements from their accounts without any deadline. This provision allows HSA owners to determine with each eligible expense whether to reimburse it from the HSA now (thus enjoying the advantage of tax-free distributions) or pay the expense with personal (post-tax) funds and preserve their HSA balances to continue to grow tax-free.
8. HSA owners don’t substantiate expenses
A frequent complaint voiced by Health FSA participants is the documentation that they must submit to their plan administrator when they use their Health FSA debit card for certain medical, dental, vision or over-the-counter expenses. Since Health FSA funds can be used only for eligible expenses, the IRS requires plan administrators like Benefit Strategies to request documentation to ensure that all transactions are for eligible expenses.
By contrast, HSA owners can withdraw funds for any purpose – though any distributions for expenses that aren’t HSA-eligible are included in taxable income and may be subject to a penalty equal to an additional 10% penalty. We advise HSA owners to maintain receipts showing the date of purchase and item bought. The IRS can scrutinize HSA transactions as part of an audit of a personal income tax return. In the absence of taxpayer records substantiating distributions as eligible expenses, the IRS can impose taxes and penalties on distributions.
9. HSA owners continue to enjoy most advantages – even when no longer HSA-eligible
Individuals must meet all HSA eligibility criteria to open and contribute to an HSA. Once they’re no longer HSA-eligible (typically when they enroll in a different group health plan or Medicare), they can’t make additional contributions. They can, however, continue to build their balances through investments and make tax-free distributions for eligible expenses. Thus, while no more money flows into the account, balances can continue to grow with investments and the tax advantages of withdrawals for eligible expenses remain intact.
10. An HSA is a great retirement savings vehicle
Because HSAs are triple-tax-free and balances are nonforfeitable, accountholders can accumulate substantial balances in their HSAs. Some accountholders do so unintentionally (their contributions regularly exceed their reimbursement needs), while others make a very conscious effort to maximize their contributions and minimize their distributions.
HSAs hold an important advantage over traditional IRAs and 401(k) plans. All three accounts allow pre-tax or tax-deductible contributions for most participants. All three allow growth that’s federal tax-free and also tax free in most states. The difference comes in the taxation of distributions. All withdrawals from traditional IRAs and 401(k) accounts are included in the owner’s taxable income. By contrast, HSA owners can make tax-free distributions for medical, dental and vision expenses, as well as over-the-counter equipment and supplies and many premiums, including Medicare Part B, Part D and even Part C premiums. Because of this tax advantage, HSA balances typically between 20% and 35% more eligible expenses than the same balances in a traditional IRA or 401(k). That’s an important consideration for active employees when determining in which account – an employer-based retirement plan, a traditional IRA or an HSA – to contribute the next $100 or $1,000 of retirement savings.
11. HSAs outlive their owners
HSA owners name one or more primary beneficiaries (and contingent beneficiaries) at the time they open their HSAs. They can change their designated beneficiaries at any time thereafter. Upon the accountholder’s death, the fate of the HSA depends on whom the accountholders named as beneficiary:
If the beneficiary is the HSA owner’s spouse, the HSA passes intact to the spouse. The spouse enjoys all the tax benefits and accepts the restrictions (distributions for non-eligible expenses are subject to income tax and possible penalties) and the late accountholder.
If the beneficiary is a non-spouse, the HSA is liquidated and the cash given to the beneficiary. The beneficiary may incur an income tax liability. Because the HSA is no longer in place, the funds are no longer tax-advantaged. At the same time, the beneficiary can spend the funds on any items without tax implications (other than potential income taxes applicable to receipt of the funds).
If the HSA owner didn’t name a beneficiary, the HSA is liquidated and the funds are distributed according to the laws of the state whose estate laws govern disposition of the estate.
Survivors can withdraw funds to pay the late accountholder’s final eligible expenses up to a year after death with no penalty.
There you have it – 10 great reasons to own an HSA. We hope that you begin to grasp the power of HSAs and the role that they can play in your financial future.
To learn more about HSA eligibility, contribution and distribution rules, please review our publication, Health Savings Account GPS: The authoritative guide to HSAs.
To learn more about a Benefit Strategies HSA, please click here, call us at 888-401-3539 or e-mail us at email@example.com.
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