With healthcare costs rising year after year, many are looking for ways to provide for health-related expenses. The good news is that there are tools available to not only cover healthcare costs but at the same time provide tax savings. Not only that, but one can potentially help you add to your retirement nest egg.
The first and most popular alternative is the Health Savings Account (HSA). An HSA must be used in conjunction with a High-Deductible Health Plan (HDHP). If you are currently enrolled in your employer’s health benefits HDHP, you have the ability to save additional funds and take advantage of the benefits of an HSA.
The HSA can provide a triple tax advantage. First, you can benefit by making pre-tax contributions to the account (contributions are not counted as taxable income). Next, the funds in the account accumulate tax-deferred earnings. Finally, when you withdraw funds to pay Qualified Medical Expenses, the distributions are tax-free. In other words, by putting dollars aside through your HSA, you can accumulate savings for qualified medical expenses while also receiving significant tax advantages. When possible, be sure your contributions to an HSA flow through a Section 125 cafeteria plan, which avoids all federal, state, and local taxes.
As mentioned above, in order to receive the tax benefit on withdrawals, you must use the withdrawal for what the IRS deems as a Qualified Medical Expense for yourself or any dependents covered by your HDHP. Generally, expenses must be primarily to treat or prevent a physical or mental injury or illness. Please check with your advisor, health benefits professional, or HR representative if you have questions about what constitutes a Qualified Medical Expense. You can also refer to IRS Publication 502.
While the HSA is a great tool to accumulate funds for medical expenses, you also can take distributions for reasons other than a Qualified Medical Expense or to accumulate these savings as additional retirement dollars. However, if you do take withdrawals from your HSA for reasons other than a Qualified Medical Expense, you will have to pay income tax and a 20% penalty on the withdrawal amount. On the other hand, if a withdrawal for a non-medical expense takes place after the age of 65, no penalty applies.
For the calendar year 2023, the IRS allows an individual to contribute up to $3,850 to an HSA (for a family, up to $7,750). For individuals over the age of 55, the IRS also allows a catch-up contribution of an additional $1,000.
Another option that can be available through your health insurance provider is a Flexible Spending Account (FSA). An FSA also offers pre-tax contributions to build up funds to pay for certain expected, out-of-pocket health care costs. These may include health plan deductibles, co-pays, prescription drug costs, and other allowed expenses. FSAs are most effective for saving funds that you know you’ll use by the end of the plan year; unlike HSAs, many FSA plans have a “use-it-or-lose-it” provision.
For the calendar year 2023, the IRS allows an individual to save up to $3,050 in an FSA.
While both options can help to reduce taxable income by putting money away for healthcare expenses, there are some items that differentiate the two programs.
- An HSA can only be used by an employee who is covered by a High Deductible Health Plan through his or her employer.
- An HSA can continue to be accumulated and grow until retirement, while an FSA is typically a use-it-or-lose-it situation, every calendar year.Depending on the HSA plan offered, certain amounts of your account can be invested to try to grow the account and increase retirement benefits. While you will want to maintain a specific amount of cash in an HSA to cover Qualified Medical Expenses, you may have the ability to actively invest the remainder of the funds in the account for future, long-term growth.
- An HSA is owned by you as the individual, while an FSA is run through an employer-sponsored plan.
- If you leave employment with your current employer, you can take your HSA with you, but an FSA is not portable; if you leave your employer, any remaining funds are no longer available for your use.
While both HSAs and FSAs can provide significant benefits, one (or both) options may be best suited for your individual needs. Please contact JFS Wealth Advisors, your health benefits professionals, or your Human Resources Department for help in deciding which option may provide you with the best benefit.