Health Savings Accounts (HSA) are Catching On

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October 16, 2006

Is it the Right Move for You?

While health care costs continue to hover somewhere in the stratosphere, a down-to-earth strategy for reducing your personal costs is gaining a solid footing. After nearly three years, health savings accounts (HSAs) are catching on as a simple and sensible way to reduce health insurance costs while taking advantage of a generous income tax deduction.

As we reported in Issue 2 of Tax News Wire, the HSA was born on Dec. 8, 2003, when President Bush signed the Medicare Prescription Drug Modernization Act of 2003. The idea is fairly simple: provide health care consumers with an alternative to high health insurance costs, and give tax breaks as an incentive to save money to pay out-of-pocket health expenses.

More than 3 million Americans have placed one foot in the HSA camp by signing up for HSA-eligible insurance policies. But only a fraction of that total — an estimate 26 percent — have taken the second step and opened an HSA. Lack of awareness may be one reason. Lack of understanding is almost certainly another. If you fall into either of those groups, this simplified explanation of how an HSA works may help.

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How an HSA Works
A health savings account looks and acts a lot like an Individual Retirement Account (IRA), that stalwart retirement savings option that has been building wealth and reducing income taxes for more than two decades. There are important differences, but the similarities include —

  • Tax-deductible contributions (with limits)
  • Tax-free withdrawals (for eligible expenses)
  • Tax-free earnings
  • Flexible investment options
  • Available whether or not deductions are itemized

Before an individual can establish an HSA, he/she must first be covered by a qualified high deductible health insurance policy, with out-of-pocket minimums of $1,050 for a single person, and $2,100 for family coverage. It doesn't matter if this coverage is offered by an employer or is purchased by an individual.

Anyone who has shopped for health insurance knows that, generally speaking, the higher the deductible (expenses you agree to incur before the insurance company starts paying), the lower your monthly premium will be. In an employer-sponsored group plan, everyone can have an HSA plan, even those who are chronically ill. No one can be rated higher or declined coverage in a group health plan, so everyone benefits from significantly lower premiums.

What to do with those savings? That's the second part of the HSA formula — a savings account established by the eligible individual and contributed to by the individual and/or the employer. The idea is for the money saved by lower insurance premiums to be invested in the HSA for future out-of-pocket expenses.

When qualified medical expenses are incurred, funds can be withdrawn from an HSA to cover those costs. There are limits on how much money can be contributed to the account. In 2006, contributions up to $2,700 for individuals and $5,450 for families are tax deductible. There are no limits or phase-outs based on income.

In order for a withdrawal to be tax-free, it must be used to pay medical expenses for the account holder, spouse or dependents. Tax-free withdrawals can not be made to pay health insurance premiums. Tax will be due, plus a 10 percent penalty, if withdrawals are made for any reason other than qualified health care expenses.

The rules change somewhat when the account beneficiary reaches the Medicare-eligible age of 65. At that point, withdrawals can be made for any reason. Federal income tax will be owed on the withdrawals, but the 10 percent penalty will not apply. The penalty is also waived if the account beneficiary becomes disabled or dies.

What constitutes a qualified expense also changes at age 65. Tax-free withdrawals can be made to pay health insurance premiums, including Medicare Part A and Part B premiums, Medicare HMO premiums, and the employee's share of premiums for an employer-sponsored plan.

One of the few downsides of reaching age 65 is that additional HSA contributions can not be made after that birthday is reached.

Is an HSA right for you?
Everyone can use another tax deduction, but before making a commitment to a health savings account, consider these questions—

  • Do you already have insurance? If so, inquire as to whether your current insurance plan is HSA eligible. If you are covered by Medicare, you can not have an HSA. On the other hand, more employers are offering the high-deductible/low premium option for health insurance, along with HSA investment options.
  • How much do you spend annually on health care? High deductible health insurance favors those who make relatively few insurance claims. If the HSA is fully funded but few withdrawals are made, most of the contributions stay put and gain value.
  • How old are you now? The younger you are, the more years for unused contributions to increase in value. If you're 55 or older, you can add up to $700 to your tax deductible contribution limit in 2006. The amount goes up every year, topping out at $1,000 in 2009 and beyond.

Because it brings in elements of health insurance, retirement savings and tax planning, choosing a health savings account may not be a task for the "do-it-yourselfer." Call the professionals at your local Clifton Gunderson office for information, strategies and unique insights, or e-mail [email protected].

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Clifton Gunderson LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Clifton Gunderson LLP or other tax professional prior to taking any action based upon this information. Clifton Gunderson LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

If you would like to contact us for more information, please call us at
1-888-CPA-FIRM or email us at [email protected].


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