Regardless of where you stand politically on President Obama’s Affordable Care Act (ACA), it’s safe to say that many of our clients have been taking notice of the law and how it will impact their lives. And while the ACA has certainly added more complexity to an already complex world, part of the joy of advising clients is finding ways to take advantage of the opportunities that legislation creates (whether intentional or unintentional). One such opportunity that has presented itself through the Affordable Care Act involves the use of a Health Savings Account (HSA).
HSAs are relatively new (created in 2003), so it is reasonable to expect that many people may not fully understand them. An HSA is a tax-advantaged account that is available only to individuals who enroll in a high-deductible health plan (HDHP). As the name implies, HDHPs have higher deductibles, which are offset by lower premiums. An HSA allows participants to save money – in 2013 the limit is $6,450 for family coverage plans, $3,250 for individual coverage – to cover their portion of current or future health care expenses. By paying lower monthly premiums for health insurance coverage, families or individuals should feel encouraged to put the cost savings on the premiums into their HSA. They can then use the funds at their discretion at any point in the future, provided they have associated qualified medical expenses. Limiting the withdrawals from the HSA allows the unused portion of the funds to be invested and potentially grow tax-free over time. It is this tax treatment that really sets HSAs apart from other medical savings vehicles authorized by the Internal Revenue Code.
Tax highlights regarding HSAs
- Contributions to HSAs are tax-deductible.
- For qualified health expenses, they are not subject to taxation.
- After age 65, distributions for any purpose can be made free of penalty, but will be subject to ordinary tax rates if not taken for qualified medical expenses.
The above tax dynamic might sound familiar to you. This is because these characteristics are very similar to the ones found in IRAs, with the noted exception that HSA distributions are tax-free if used for qualified medical expenses. And with many studies estimating that couples will need in excess of $200,000 to pay for health care costs in retirement, contributing to an HSA early and often can be a wise decision for anyone who is eligible, but particularly for young adults who have long investment time horizons.
Thanks to a particular passage of the Affordable Care Act, families with adult children are now able to recognize even greater benefits from the use of HSAs. The ACA states that young adults under the age of 26 have access to health care coverage via their parent’s plan. However, once they are no longer dependents of their parents (the general rule is over age 19 or when they are no longer full-time students), parents are unable to use their own HSA to pay for their child’s medical expenses – instead, the child is able to set up a separate Health Savings Account.
How families can take advantage of HSAs
- A young adult fresh out of college is struggling to find a job that offers quality health insurance benefits. Therefore, they stay on their parent’s coverage and establish their own HSA through their parent’s plan. In this scenario, the parents and the child can separately contribute $6,450 to their respective HSAs in the same year.
- While it is likely that the child will be unable to make the maximum contribution to their HSA while still meeting their other savings/spending obligations, their parents (or other extended family members) could make the contribution on their behalf, without limiting their own HSA contribution.
- The unused funds grow tax-free and are available for future year medical expenses.
Following these steps allows young adults to get a serious jump-start on saving for potential health care costs. Assuming a 5% growth rate, and that no withdrawals are taken from the HSA, contributing the maximum amount to the child’s HSA from ages 23 through 25 will leave a balance of nearly $150,000 by the time they are 65 years old.
Ideally, both you and your child would rely on the HSA as infrequently as possible, giving your contributions time to take advantage of the tax-free growth. If it’s possible, fund any medical expenses out-of-pocket, but do not forget to keep good records. Record-keeping is vitally important, as maintaining medical expense receipts – even if you don’t use the HSA to offset them in the current year – allows them to be used in future years. By executing this strategy, you’ll be able to distribute funds from the HSA after age 65 for any purpose – tax and penalty free – up to the amount of documented medical expenses that you have accumulated throughout the years (as well as for any future medical expenses). You’ve essentially created a Roth IRA.
Saving for future health care expenses has never been more important in light of the changing laws, rising medical costs, and increased longevity. Currently, HSAs represent one of the best devices in place to keep pace with these issues. Families who use HSAs wisely will be taking a big step toward not only securing their own financial future, but their children’s as well.