HSAs 101: What You Need to Know About How HSAs Work

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By Jennifer Kelly

Whether we like it or not, we're stuck in an era of rising health care costs -- and even with insurance, we're all increasingly bearing the brunt of it.

According to one study, employees' share of medical costs -- including contributions to their insurance plans and out-of-pocket costs -- is projected to jump by more than 52 percent between 2010 and 2015.

Meanwhile, those purchasing plans through insurance exchanges set up through the Affordable Care Act can expect a hike too -- one estimate says the average premium will rise more than 5 percent next year.

On top of all that, the country is dealing with extensive medical debt: Americans pay three times more toward health care–related debt than they do toward credit card and other bank-associated debt combined.

So what gives?

You could debate for hours all the reasons that contribute to the health-related pinch to our wallets -- some political, some economic, some tied to our own ailing health -- but one trend seems to be holding true: More companies are increasingly offering high-deductible health plans, or HDHPs, to their employees in an effort to cut back on their own overhead.

%VIRTUAL-pullquote-There's no question that high-deductible plans are becoming more common.%At first glance, most people tend to want to shy away from HDHPs because they're dissuaded by the high out-of-pocket costs they have to reach before their insurance kicks in. But what many workers may not realize is that HDHPs are often accompanied by a Health Savings Account, a tax-advantaged account that holds money intended to cover medical costs.

"There's no question that high-deductible plans are becoming more common," says David Blaylock, a certified financial planner at LearnVest Planning Services. "And I have a lot of clients who have been provided an HSA option through their company. They're a little hesitant at first, but once they understand that it allows them to save in an account of their own -- that's not necessarily tied to the employer -- they usually prefer that route."

In fact, HSAs (and their linked high-deductible policies) have been growing rapidly both in the private markets and on the new public exchanges. Devenir, a Minneapolis-based HSA investment firm, says its assets in HSA accounts have reached almost $23 billion -- a 26 percent increase over last year.

With open enrollment season in full swing, you may be wondering, "Is an HSA right for me?" To help you land on the answer, we've put together a 101 guide on how they work -- and what makes them different from other types of savings vehicles.

HSA Basics

Much like a 401(k) or IRA that you can use to save for retirement, an HSA is a savings account to which you contribute pre-tax dollars that earn interest or could be invested, depending on the options that are provided to you by the financial institution where you hold your account.

And much like with a 401(k), you can have your contributions taken straight from your paycheck -- plus, some employers may opt to make HSA contributions on your behalf.

As is the case with retirement accounts, HSAs have contribution limits that are set by the IRS every year. For 2015, individuals who only cover themselves through an HDHP can contribute up to $3,350 a year; those on a family plan can contribute up to $6,650. If you're 55 or older, you can also add another $1,000 as a catch-up contribution.

But here's one big difference from a retirement account: While 401(k)s, IRAs and HSAs all let your earnings grow tax-deferred -- which means you pay no capital gains tax -- you do pay ordinary income taxes on the withdrawals you make from your IRAs and 401(k)s in retirement.

With an HSA, however, you don't pay taxes on withdrawals, at any age, as long as you're using them to cover qualified medical expenses -- which means you can get a tax break on what you put in and get out, provided the money is being used properly.

The other pro to an HSA? That money and investment growth is all yours -- there are no year-end, use-it-or-lose it or limited carryover provisions.

"I think the average account holder is getting around $25 to $40 in tax savings per month [by using an HSA]," says Todd Berkley, president of Minnetonka, Minn.–based HSA Consulting.

Another pro to an HSA? That money and investment growth is all yours -- there are no year-end, use-it-or-lose it or limited carryover provisions, as is the case with flexible spending accounts.

Of course, one of the biggest limitations to an HSA is the fact that you can't open one unless you're enrolled in an HDHP, and for 2015 that means an insurance plan with a deductible of at least $1,300 for individuals and $2,600 for families. Another caveat: An HDHP may not be the right insurance choice if you have a long-standing illness or already know that you tend to incur high medical bills you can't cover out-of-pocket.

%VIRTUAL-pullquote-If your medical costs are low, [HSAs] enable you to set aside money to cover future health care costs and, if you stay healthy, even retirement [medical costs].%"If your medical costs are low, [HSAs] enable you to set aside money to cover future health care costs and, if you stay healthy, even retirement [medical costs]," Blaylock says. "But if you have a chronic medical condition, you are probably better off in a traditional health insurance policy."

Berkley, however, believes that the slant toward healthy, wealthy participants has been overstated. His company sees participants across the age and income spectrum, with the average account holder between ages 40 and 45.

"It's not a great tax shelter for the rich, since you can only put away $6,650 a year," he says. "It's actually a [better] tax shelter for the middle class."

Another important thing to note: Since HSAs are meant to be paired with an HDHP, you can't contribute more money to them unless you are enrolled in such a plan. You can, however, keep the account open and continue to let the money grow that's already been contributed.

Decision Time: Key Things to Look for in an HSA

As with a 401(k), you might be limited to the HSA providers that your company offers. But for those who are free to choose their own, there are a plethora of financial institutions that participate -- many major banks include HSAs among their offerings.

Before you open an account, take a look at the fees you'll be charged, suggests Blaylock, because they can vary widely from bank to bank. A comparison table at the HSA Search website shows monthly maintenance fees ranging from $0 to $7, some of which are waived for people with higher account balances.

If you decide to invest your HSA funds, also consider taking a look at any additional fees that are charged by the funds that you may invest in. The higher the fees, the more you're eating into the value of your account and offsetting your tax benefits.

Beyond fees, the HSA features you value will really depend on how you intend to utilize the account.

"If you feel like you're going to use the account frequently, then convenience is probably going to be a big factor," Blaylock says. "You may want to choose a bank that offers a debit card, ATM access and other easy ways to pay."

On the flip side, if you're viewing your HSA as more of a long-term savings vehicle, then choose a provider that offers a good mix of investment options, Blaylock adds. "You may want to go with a larger company -- they're going to have a wider range of investment choices than the local credit union."

In fact, because of their tax benefits, some people view HSAs as another way to save for retirement. If you're 65 and older, you can withdraw money from an HSA for any reason -- even non-medical ones -- but the non-medical withdrawals you make will be taxed like ordinary income, which is similar to IRA or 401(k) withdrawals.

A study from Mount Sinai found that, on average, people with Medicare coverage paid more than $38,000 for medical care out-of-pocket in the last five years of life.

"Most people come in to HSAs thinking of them as a replacement for a flexible savings account. They just want to put in the amount that they expect to spend on medical expenses," Berkley says. "But I think the [next] big frontier for HSAs is in investing. The options [you have in HSAs] are generally similar to a 401(k)."

For instance, Berkley says that investors who have maxed out their 401(k) contributions can consider putting any additional retirement money into their HSA up to that contribution limit, which also helps bump up their tax benefits for the year. The other upside, of course, is that if the HSA money is used to cover medical costs in retirement, it won't be taxed at all.

"I always encourage people to first get your match on your 401(k). That's free money," Berkley says. "Then max out your HSA."

Blaylock takes a more cautious approach. "An HSA is not really a long-term planning tool, in my mind," he says. "It's really about taking care of our health needs today."

With that in mind, Blaylock encourages people to put money into their HSAs until they have enough to cover their deductible. After that, he explains, "we want to make sure they're filling other important financial buckets: emergency savings, retirement savings and college savings."

Regardless of how you use your HSA, Berkley notes that these accounts are helping to address a problem that almost no one is prepared for today -- the mounting costs of health care in retirement.

A study from the Icahn School of Medicine at Mount Sinai found that, on average, people with Medicare coverage paid more than $38,000 for medical care out-of-pocket in the last five years of life.

"I think we all wish everyone was saving a little more for post-retirement medical costs," Berkley says, "and HSAs can help with that."
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