Health care costs continue to rise and take a bite out of our budgets. In part one of this post, I discussed using a Flexible Savings Account (FSA) to pay for your medical costs. The beauty of the FSA is that the money you contribute comes out of your pay check before taxes. That means the net result is you are getting your medical benefits tax-free. That could be a savings of 15-25% or more depending on what tax bracket you fall in.
I have used FSA’s many times in the past to save money. As long as you are careful about not over funding it since you lose any unused money at the end of the year, FSA’s can be very useful.
There is another alternative for paying your medical expenses with tax-free dollars called a Healthcare Savings Account or HSA.
At a high level an HSA works similar to an FSA. In both cases you contribute dollars before taxes to an account that can then be used to pay for healthcare related expenses. There are some very important differences though between the two.
What is an HSA
First a Healthcare Savings Account is a real savings account at a banking institution. You may only use the funds in this account for qualified medical expenses. You can fund this account through payroll deductions or by making transfers from your regular banking account. If you fund it through bank transfers, you will not get an immediate tax benefit, but will be able to deduct those contributions on your tax return.
Benefits to an HSA
The first and biggest benefit to an HSA is there is no use it or lose it provision like there is for an FSA. If you do not use all the money you put in for a particular year then it simply carries over to the next year.
Another plus of the HSA is there is currently no income limit as to who is eligible. Most of the retirement tax savings plans like an IRA or a Roth have income limits associated with them. If you make over a certain amount, you are no longer allowed to gain the tax benefits of these programs. This is not true of the HSA, so if you are a high income earner, the HSA provides you a way to protect at least a little of your money from taxes.
In some cases you may be able to invest some of your excess funds in your HSA in more aggressive investments like mutual funds.
And of course the prime advantage as with the FSA is it enables you to get a portion of your medical care tax-free, which in effect is like saving 15-25% or more depending on your tax bracket.
Like the FSA, it also gives you the benefit from a budgeting standpoint of spreading those medical costs out equally over the course of the year so you don’t get hit with a large bill in one month. The nice thing with an HSA is that if you know you have an expensive medical procedure in your future like LASIK surgery or perhaps braces for the kids, you can actually save up for these over a period of years since you are allowed to carry excess funds over. The FSA doesn’t give you that option since it is use it or lose it.
Drawbacks of an HSA
So if there are all these benefits to an HSA. why would anyone ever choose an FSA over an HSA?
Unfortunately, there is one major drawback to the HSA. You can only qualify for the HSA if you have a High Deductible Healthcare plan. That means you will be responsible for more health care costs out of pocket before your insurance starts to kick in.
Another disadvantage to the HSA is you can only use the money you have put into the account. In the article on the FSA I noted that a benefit was that all of the money you commit to contribute that year becomes immediately available. So if you plan to contribute $100 a month then that entire $1200 is available to you from January 1st on regardless of whether you have actually contributed it yet or not. This is not true of the HSA. In the HSA the money isn’t available to you until you have placed it in the account.
There are limits to how much you can contribute to your HSA in a given year. For 2012 those amounts were $3,100 for an individual or $6,250 for a family. Those values change each year. Also if you are over the age of 55 and not enrolled in Medicare your limits can be higher.
Who should consider an HSA
So given those benefits and drawbacks, who is a good candidate for an HSA vs. and FSA.
If you are fairly healthy and rarely see a doctor the HSA is a great choice as you will be able to build up a nice sum tax-free in your HSA and in the event you do have a major medical event down the road you’ll have plenty of money there to cover it.
If you are self-employed or are responsible for providing your own health care insurance, the HSA can be a particularly good deal. By combining a high deductible plan with an HSA you should be able to get a much lower rate on your insurance along with the tax benefits of the HSA. You could be able to save significantly on a very expensive item.
If you anticipate having high medical costs in the coming year or have a serious chronic medical condition then an HSA probably won’t work out so well for you. The high deductible will probably eat up any savings you might have been able to achieve.
One positive alternative is in most cases you have the option to switch back and forth from year to year. You can’t contribute to your HSA in the year you don’t have the high deductible plan, but if you know you are going to have an expensive medical procedure you could switch for that year to a lower deductible plan. You can not add money to your HSA while you have the low deductible health care plan in place though you can still use that money for medical expenses. You can then restart adding money to the HSA when you go back to the high deductible health care plan in a future year.
For more detailed information on HSA’s you can check out IRS Publication 969.
A great way to save on health care costs
October is a time when many companies have the benefit enrollment period for the coming year. The bottom line is whether an FSA or an HSA makes more sense for you, these are great ways to save a little money on your taxes and ease the high cost of health care. I have done both at various times over the years and I can’t recommend them highly enough.