Each year consumers face the difficult task of making an irrevocable choice about their health care plan without really knowing what the upcoming year has in store for their family’s health. You have to decide between plans with higher monthly premiums and lower deductibles (e.g. a Preferred Provider Organization (PPO) or Health Maintenance Organization (HMO)) versus plans with lower monthly premiums and higher deductibles (e.g. High Deductible Health Plans (HDHP)). Often, this comes down to whether a Health Savings Account (HSA) or Flexible Spending Account (FSA) is the best savings option for you. Your objective should be to get the coverage you need for the lowest out-of-pocket cost.
According to the Kaiser Family Foundation Employer Health Benefits 2018 Annual Survey, 49 percent of American workers enrolled in PPOs, while only 29 percent enrolled in HDHPs with a savings option. Why aren’t more Americans choosing the Health Savings Account (HAS) given its flexibility and tax advantages? One reason is that only 22 percent of employers are offering the HDHP/HSA in their plan choices. Another possible reason is that employees may not fully understand the HSA, so they are choosing traditional plans. To provide some color around the differences, I’ve broken down what an FSA offers versus an HSA.
Flexible Spending Account (FSA)
The FSA is a tax-advantaged plan offered by employers that you can pair with a traditional health plan, like PPOs or HMOs, to cover the cost of out-of-pocket health expenses. For 2019, you can contribute up to $2,700 that is reimbursable for eligible medical expenses. Contribution amounts to the plan must be set at the time of open enrollment and cannot be changed until the following open enrollment period.
Before the Patient Protection and Affordable Care Act, this account was typically referred to as the “use it or lose it” plan since any funds left in the account were forfeited to the employer. However, employers may allow plan participants to carry over up to $500 for the following year. In my opinion, that is not all that “flexible.”
Health Savings Account (HSA)
Similar to an FSA, an HSA is a tax-advantaged savings account to cover out-of-pocket health expenses. Unlike an FSA, the money you put into an HSA remains regardless of whether you spend it during that year or not. In order to open an HSA, you must also be enrolled in a High-Deductible Health Plan (HDHP) for yourself or your family. For 2019, you can contribute up to $7,000 (family coverage) or $3,500 (self-only coverage) to an HSA all while leveraging multiple tax benefits.
HSAs are often recognized as a triple-tax benefit savings account. First, all contributions to the HSA are pre-tax deductions for you, regardless of who contributes to the account, and contributions made from your pay are not subject to social security (FICA) and Medicare taxes. The account interest and investment earnings grow tax-deferred. Finally, as long as you withdraw money from your HSA for Qualified Medical Expenses (QMEs), the money used is tax-free regardless of age. A non-QME withdrawal before age 65 is 100 percent taxable and subject to a 20 percent penalty, but once you reach age 65, the penalty for non-QME withdrawals drops off. For example, you can use money in your HSA to buy a boat on your 65th birthday, and the tax treatment is similar to a 401(k) or an IRA withdrawal.
In addition to the triple-tax benefits of the account, there are multiple advantages to using an HSA. For instance, if you are age 55 or older, you can contribute up to $1,000 in ‘catch-up contributions’ to help save for retirement. Your employer can also contribute money into your HSA on your behalf. Similar to a 401(k), at termination you can roll over the HSA balance to a new HSA plan tax-free. Unlike the FSA, changes to your contribution election can occur during the plan year regardless of whether you experience a qualifying event (e.g. change in marital status or number of dependents). Another advantage of an HSA is that your spouse can inherit your HSA and use it to cover his or her QMEs in the event that the account holder passes away before.
Also, most HSA custodians offer a platform to invest a portion of your account in mutual funds. If you do decide to invest in mutual funds, it is important to remember that these investments are subject to market risk that can fluctuate in value resulting in potential losses and gains over time. If this is something you and your family are interested in pursuing through your HSA, make sure you review the fund prospectus including investment objectives, risks, charges and expenses, and consider working with a CFP® professional to help create your investment plan.
The Best of Both Worlds
By rule, participating in a general healthcare FSA makes you ineligible to contribute to an HSA. This is true even if your spouse participates in a general healthcare FSA through his or her employer.
However, a wrinkle in the rules allows you to participate in a limited-purpose FSA and still fully participate in the HSA. The limitation restricts reimbursable FSA expenses to only dental and vision expenses. Therefore, you can pay for dental and vision expenses with tax-free dollars through the limited purpose FSA while accumulating more money in the HSA.
The Holy Grail
Many in the financial planning community refer to the HSA as the “holy grail” of investment vehicles. Never has there been an opportunity to accumulate wealth in which the contributions and earnings have been nor will be subject to a penny of federal income tax (even FICA taxes) when used to pay for QMEs. For that reason alone, the HDHP/HSA is worthy of serious consideration in your financial plan to meet healthcare needs today and in the future.