Perhaps, most Americans underestimate the incredible value proposition that Health Savings Accounts (HSAs) can offer.
For those that have qualified High-Deductible Health Plans (HDHPs) which typically consists of a $1,350 annual deductible for individuals and $2,700 deductible for families, HSAs provide a means to save and invest for any future out of pocket medical expenses.
If your current health plan provides a low deductible or small copay, you may be thinking that potentially spending thousands of dollars in out of pocket medical expenses seems absurd. However, the premiums required for HDHPs typically come out to much lower monthly amounts that can be saved and invested for any future costs. Over the long-term, you may be surprised how much you actually save depending upon your health.
As an added benefit, many employers directly contribute to HSA programs in order to jumpstart their employees’ savings or offset any upfront medical costs.
Instead of funding the insurance company’s bottom line, you keep more of your money but also bare the responsibility of picking up any expenses until reaching your deductible. Once you hit your deductible, insurance typically kicks in to cover the majority of the cost.
With HDHPs, you also reach a ceiling of max out of pocket expenses to where insurance covers 100% of the bill. In 2019, the out of pocket max comes in at $6,750 for individuals and $13,500 for families.
For those with chronic illnesses this ceiling can be a welcome reprieve from medical bills.
While the contribution limits to HSAs may be fairly small ($3,500 for individuals and $7,000 for families in 2019) compared to other accounts such as 401(k)s, these health savings accounts pack a powerful punch – especially, after multiple years or decades of accumulating money in your account.
Tax-Advantaged in Three Ways
The beauty of HSAs comes from the tax breaks you receive in 3 primary ways:
- The tax deductibility of contributions
- The tax-deferred growth of any investments gains and dividends
- The tax-free distributions for qualified medical expenses
Deducting Contributions to HSAs
With all of the money you save on monthly insurance premiums, you now have the ability to sock that money away elsewhere and “self-insure” up to your deductible and out of pocket max.
In order to incentive you to save for medical expenses, the U.S. Treasury essentially subsidizes the contributions you make to your HSA by allowing you to deduct the amount you contribute from your adjusted gross income come April.
In effect, this lowers your taxable income, producing meaningful tax savings.
As an Example:
If you are single and your effective tax rate hovers around 25%, by contributing $3,500 to your HSA, you save nearly $900 in taxes.
Instead of going to the tax man, this money can be saved to offset the higher out of pocket expenses
Tax-Deferred Growth and Tax-Free Distributions for Qualified Expenses
Not only do contributions to a HSA allow for a deduction, the balance can be invested in a tax-sheltered account where it can grow and compound.
If you invested in an ordinary brokerage account, you would be immediately taxed on any dividend distributions. When you sell the stocks or funds, you incur either long-term or short-term capital gains on the appreciation depending on how long you held the investment.
By contrast, dividends and gains in a HSAs are not subject to tax if used for medical expenses.
However, if you do tap your HSA for unqualified distributions, you will have to pay tax and a hefty penalty of 20%.
Although, as an added benefit, after age 65 any withdrawals come penalty free. While you will pay taxes on any gains for unqualified, non-medical expenditures, this functions in the same way a Traditional IRA or 401(k) operates.
However, by the time you reach 65, chances are that you will certainly have hefty out of pocket medical expenses even if covered by Medicare.
Instead of tapping retirement accounts for these costs, you simply withdraw money from your accumulated balance in your HSA, pay the medical expenses, and allow the other accounts to continue compounding for future use.
Either way, sheltering your investment from taxes in a legal way offers a ton of value to pay for your future healthcare costs.
Keeping a Cash Balance for the Deductible
While investing 100% of your contributions may be tempting, keeping a cash position equal to your deductible or even max out of pocket expense for one year may be prudent depending upon your ability to cash flow any medical bills.
Unless you plan or have the ability to fund any minor medical expenses out of pocket from your monthly cash flow, keeping a cash balance may help you sleep better at night while the remaining balance grows.
However, if you do have substantial savings outside of your HSA or other restricted accounts, you could use this money to cash flow your medical bills rather than tapping this sheltered money. If you have the discipline and patience, opting to sacrifice outside money allows your account to build and compound for future expenses.
3. Tax-Free Distributions for Medical Expenses
Because you may be used to a low copay with your current insurance plan, the downside from HDHPs pertains to your responsibility to cover the entirety of the bill until your expenses meet your deductible.
No Taxes on Any Gains for Qualified Medical Expenses
However, the most lucrative aspect of the HDHP with an HSA comes from the tax-free distributions of the entire HSA balance (including investment gains) if used for qualified medical expenses.
Qualified expenses range from normal doctors visits to x-rays and lab fees.
For healthy individuals who seek a normal amount of medical care in a given year, you will probably pay more with a normal PPO or HMO because your fixed monthly medical expenses will be higher due to the premiums for these plans. After all, insurance companies employ armies of actuaries and statisticians to ensure they generate profits for shareholders. Their profitability comes from what they charge you for coverage less negotiated prices with their network of providers.
Therefore, unless you go to the doctor more than average but not enough to surpass the maximum out of pocket for your HDHP, you more than likely end up spending more on premiums and copays than you would otherwise with a HDHP even counting doctors visits.
You Self-Insure Up to Your Deductible
For those who can exercise financial discipline and invest the lower premium amounts over the course of several years, building a substantial sum in your HSA helps you self-insure for any minor medical expenses.
Remember, you HDHP still covers major expenses which would typically cost tens or hundreds of thousands of dollars. You would just be on the hook for your max out of pocket rather than a smaller deductible plus percentage of the bill.
In order to comfortably self-insure, you should start by ensuring that you have enough cash reserves or accumulated wealth to at least fund your deductible should misfortune strike.
Use Any Savings from Premiums as a Start to Self-Insuring
With a HDHP, your base monthly medical expenses will probably be drastically lower due to reduced premiums to your insurance provider.
When you go to the doctor in a given month, you pay the full price of the visit. Therefore, you could have several months out of the year where you only have the low premiums and one month where you have a $150 or more doctor’s visit. In this scenario, you almost certainly saved money due to the premiums saved throughout the year.
Additionally, many companies that offer their employees a high-deductible option contribute a certain dollar amount to their employees’ HSAs each year to help offset any costs you may bare. Therefore, you should check and see if this benefit comes standard with your HDHP option and include this contribution in your analysis.
Even though you have probably paid less in total out of pocket medical expenses and premiums, you must make sure that you have put this money back just in case. For many, they may find forcing themselves to stick money back to be difficult. With normal insurance premiums, typically, the amount comes drafted as a payroll deductions.
Therefore, if you do elect a HDHP with a HSA, automatically deduct at least the difference in your premium amounts into an HSA to start saving for any future expenses.
What About People with Chronic Illnesses?
Additionally, if you have a chronic illness or expect to exceed the maximum out of pocket in a given year, a HDHP with an HSA may actually end up saving you money compared to a PPO or HMO.
Because your HDHP caps the total possible out of pocket max expense, all of the healthcare costs you accrue after meeting the total out of pocket max come covered by insurance.
Often, those with chronic or serious debilitating illnesses reach their out of pocket maximum fairly quickly. Instead of being on the hook for 20% after insurance, these individuals will not need to worry about any further medical care costs.
As an added benefit, you may quickly run your expenses through your HSA before paying the bill. This allows you to claim a tax deduction on the amount sent through the HSA.
HDHPs + HSA: Great Tools to Build Wealth and Efficiently Pay for Medical Costs
Overall, a HDHP with a HSA provides a tax-efficient and generally lower cost way to pay for your healthcare expenses.
However, you must assess for yourself if a HDHP works best in your own situation.
For example, when assessing my own personal HDHP and PPO from my employer, I compared the difference in the monthly premium amounts for each plan, the co-payment amount for the PPO, the deductible limit for the HDHP, and out of pocket maximum for a worst-case scenario.
After running the numbers, I found my monthly premiums would be cut nearly in half by choosing the HDHP which would have freed up around $80 per month in my plan. However, in my first year of employment, I had not yet generated the net worth and financial means to cover the deductible day 1 should I have had a medical event.
Therefore, I chose the PPO until I had the financial means to self-insure the higher deductible amount.
However, after my first year of working, I built up enough nest egg to cover any out of pocket costs. Then, I switched my plan to the HDHP and began contributing the difference in the premium amounts to a HSA. While my payroll deductions remained the same, instead of all of my money going to the insurance provider, half went to them while I saved and invested the other half.
Since certain preventative costs come covered even under HDHPs, my primary care physicians visits do not have an additional cost. Also, because I am healthy and rarely need medical attention, my accounts have grown thanks to my monthly contributions and investment returns.
Even if I do have medical expenses in the future, I plan to fund out of pocket and simply allow the investments in my HSA to grow and compound as a second “retirement account” that could be used down the road.
HDHPs with HSAs give you back the power to exercise control on the escalating costs of insurance premiums and medical expenses by reducing your monthly expenses and empowering you to save and invest for your future needs.