Many experts expect healthcare costs will continue to rise, underscoring the importance that advisors help their clients plan ahead. One increasingly popular method is the health savings accounts (HSA), an investment account that allows the proceeds to be distributed for medical expenses, tax free.
Since the inception of HSAs, enrollment in HSA-eligible health plans has grown, to about 17 million policyholders and their dependents, and nearly four out of five HSAs have been opened since the beginning of 2011, according to the National Association of Plan Advisors. Meantime, a Devenir Research study shows that total HSA assets have soared, from $1.7 billion in 2006 to more than $45 billion in 2017, and the rate of growth is expected to accelerate through 2019. (See Chart 1.)
From Here to Longevity
Between rising healthcare costs and insurance premiums and greater longevity, it’s easy to see why more people are funding HSAs and more employers are offering them. According to Fidelity’s Heath Care Cost Estimate, a 65-year-old couple who retired in 2017 will need $275,000 (in today’s dollars) to cover just healthcare costs in their golden years—nearly 5.8% more than the previous year’s estimate of $260,000. That’s the highest estimate since such projections started in 2002.
An HSA offers an opportunity to pay medical expenses in retirement tax free. Distributions can be made at any time (unlike flexible spending accounts, which follow “use it or lose it” distribution rules), which, with smart planning, offers a younger individual to fund his or her HSA today and let the account grow without distributing any proceeds until later in life, potentially as late as retirement.
HSAs are distinctive compared with their tax-advantaged account counterparts (e.g., IRAs, qualified plans, etc.). As Nevin Adams, chief of marketing and communications for the American Retirement Association put it last year, “HSAs provide their account owners a triple tax advantage: contributions to an HSA reduce taxable income, earnings on the assets in the HSA that build upvtax free, and distributions from the HSA for qualified expenses that are not subject to taxation.” HSAs also can enable employers to lower premiums by creating higher deductibles and increase “cost sharing” with employees.
HSA owners receiving contributions pretax through an employer, either employer contributions or employee payroll deferral through a Section 125 plan, also avoid FICA payroll taxes (e.g., Social Security and Medicare). In other words, funding an HSA through payroll can save an HSA holder 7.65% in payroll tax (the employee’s half of the 15.3% payroll tax).
Of course, clients (and their spouses and dependents) have medical costs throughout their lives.
So, if at all possible, it’s advisable to encourage them to tap other funds, while their HSA grows.
Note that tax-free distributions are allowed for a spouse even if he/she has medical coverage that
is not HSA eligible.
HSA eligibility is a mixed bag. For example, there is no requirement to have earned income to contribute to fund an HSA. Further, there is no income test to satisfy: contributions are fully tax deductible. However, eligibility requires an individual to be enrolled in a high deductible health plan or HDHP. Additional eligibility requirements include that an individual is not enrolled in Medicare and who cannot be claimed as a dependent on someone else’s tax return.
Note: This is not an exhaustive list. For a complete overview of eligibility, see IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans.Be sure to consult with your tax professional and confirm that your plan is qualified as an HDHP.
In 2018, the maximum funding limit for an HSA is $3,450 for an individual ($4,450 for those age 55-plus) and $6,850 for family coverage ($7,850 for those age 55-plus). The contribution deadline is the employee’s tax-filing deadline, not including extensions. So, you still have time to make a 2017 HSA contribution. For 2017, the contribution limits are $3,400 (single coverage) and $6,750 (family coverage), plus an additional $1000 catch up for the those individuals age 55 and older.
Each tax year that you have HSA coverage provides you the opportunity to contribute to your HSA up to your contribution limit. In addition, in the same vein as IRAs, the IRS permits prior-year HSA contributions in the following tax year. For any given tax year, you can contribute normally to your account throughout the year (January 1–December 31).
As previously mentioned, IRS rules allow eligible taxpayers to make prior year contributions to their health savings accounts. But if you’re doing that in the following tax year, be sure to code it as a contribution for the prior year with your HSA custodian. This is because a contribution made in say, January, can be used for either the current year or prior year. Your HSA custodian needs to know how you handle this contribution and to which tax year you want it to count.
The deadline for this prior-year contribution is the day your taxes are due, generally April 15. You can make contributions to your HSA for 2017 until April 17, 2018.
Tip: An individual does not need to remain an eligible individual to make a prior-year contribution. For example, your HSA-eligible insurance can end, but you can still wait until the following year to make prior-year contributions.
Generally, distributions from an HSA to pay for medical expenses are tax and penalty free. Qualified expenses include most medical, dental, vision care, and medications prescribed by a doctor. On the other hand, nonqualified distributions (i.e., those not used for medical expenses) are taxable and subject to a 20% penalty (not the usual 10% penalty associated with most retirement accounts). Interestingly enough, though, in the case of distributions taken after age 65 (not 591/2), the 20% penalty is waived (though nonqualified distributions are still taxable for those older than 65). With regard to a qualified distribution, the penalty also is waived for disability or, if withdrawn as a non-spouse beneficiary, after the passing of the HSA owner.
HSAs also offer a little known benefit (in coordination with your IRA): An individual once (in his or her lifetime) can transfer the proceeds from an IRA (not 401(k), 403(b) or qualified plans) to his or her HSA—up to the contribution amount allowed for the year. This transfer is known as a qualified HSA distribution (QHFD). However, it would be permissible to roll over a 401(k) or other retirement plan from a former employer to an IRA and, subsequently, transfer the assets to an HSA. The transfer is permitted from an individual’s IRA in which he/she is the account owner or from an inherited IRA in which he/she is the named beneficiary. The rollover amount cannot be more than the annual HSA contribution limit minus any contributions that are made for the year.
Why would someone transfer his/her IRA assets to an HSA? One benefit would be to augment his/her HSA savings in the event of an immediate, urgent, and potentially expensive medical procedure. Another strategy involves moving all one’s pretax “taxable dollars” to an HSA, leaving behind only aftertax dollars, which subsequently can be moved/converted to a Roth IRA reducing or potentially eliminating the tax burden.
Tip: Basis is not permitted to be transferred from an IRA to an HSA. Also keep in mind:
- A transfer can only occur once per lifetime.
- The transfer amount is determined by the contribution limit for the individual in the year of transfer.
- IRA proceeds must be moved as a direct transfer. A 60-day rollover is not permitted.
- Eligible IRAs include traditional, Roth, SEP, or SIMPLE. However, the SEP or SIMPLE must be inactive.
- Distributions are not subject to the “pro-rata” rule. In other words, an individual is not permitted to move aftertax dollars; only pretax dollars are allowed to transfer.
A QHFD also applies to inherited IRAs.
Be sure to engage a tax professional, as there is no special 1099-R coding to report the transfer as a QHFD.
An individual must remain HSA eligible for a one-year period after a QHFD to avoid taxes and penalties.
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