Do You Need a Health Savings Account?

Here are the details on a terrific way to cut health-care costs dramatically.

HIGH HEALTH-CARE DEDUCTIBLES can be a financial burden, even for folks with health insurance. But thanks to a provision in the Medicare law, those costs can now be covered with pretax dollars through a relatively new tax break called a Health Savings Account (HSA). That's welcome news to self-employed folks, small business owners, employees of small to medium-sized outfits (with bare-bones health benefits) and those under age 65 who pay for health care on their own.

How HSAs Work
Starting in 2004, eligible individuals can slash their federal income tax bills by making deductible HSA contributions. This will be like making deductible IRA contributions. And HSAs will apparently be just as easy to set up as IRAs (more on that later). Even better, you can qualify for the HSA break regardless of your income since there are no nasty phase-out rules for high earners like the ones that apply to deductible IRA contributions.

Now for the ground rules. You're allowed to make HSA contributions only if you are covered by health insurance with an annual deductible of at least $1,000 for self-only coverage or $2,000 for family coverage (family coverage means anything that isn't self-only coverage). People working for large companies with generous benefits won't be eligible. But potentially anyone else under age 65 is.

Assuming you meet the insurance deductible requirement, the maximum HSA contribution for 2005 is the lesser of: (1) the amount of your deductible or (2) $2,650 for single coverage or $5,250 for family coverage. (For 2006 and later years, the last two figures will be adjusted for inflation.)

You claim the writeoff for HSA contributions on Page 1 of your Form 1040 (a so-called above-the-line deduction). This means you'll get the federal tax-saving benefit whether you itemize or not. (In some states, you may get a state-tax write-off as well.)

Example 1: Say you're self-employed as a sole proprietor, partner, or LLC member. Because of your self-employed status, your only affordable health insurance option was a family policy with a hefty $2,500 deductible. With an HSA, you can make a deductible contribution of up to $2,500 for 2005 (lesser of your $2,500 insurance deductible or the $5,250 absolute contribution maximum for anyone with family coverage). If you're in the 33% federal tax bracket, your tax bill goes down by $825 (you'll have that much more cash in your pocket after filing your 2005 taxes). Not bad! You can then continue to contribute to your HSA on an annual basis, collecting similar tax savings year after year as long as your circumstances remain the same.

If you happen to be an employee with the same less-than-generous health insurance coverage, your tax results would be the same (assuming your spouse doesn't have family coverage with a lower deductible).

Example 2: Say you work for a small company that doesn't provide any employee health coverage. You have to arrange for your own health insurance, which in your case means separate policies for you and your spouse with separate $2,000 deductibles. For 2005, you can contribute up to $2,000 to an HSA set up in your name (lesser of your $2,000 insurance deductible or the $2,650 maximum for self-only coverage). Your spouse can also contribute up to $2,000 to a separate HSA set up in his or her name. So the two of you can together contribute and deduct a total of up to $4,000 ($2,000 each). If you're in the 33% federal tax bracket, this would reduce your tax bill by $1,320 with very little effort on your part. You'll collect similar tax savings year after year as long as your circumstances remain the same.

Additional Withdrawals
It gets better. As the account beneficiary of your HSA, you can also take federal-income-tax-free withdrawals from the account to pay uninsured medical expenses for yourself, your spouse, and your dependents. (However, you cannot take tax-free withdrawals to pay the premiums for your high-deductible health coverage.)

You get a bonus if you're healthy and incur minimal medical expenses. Your HSA balance is allowed to accumulate from one year to the next, and any income earned on your balance is federal-income-tax-free. So if your health is really good, you can use your HSA to build up a substantial tax-favored medical expense disaster fund over the years.

Once you reach Medicare eligibility age (65 under current law), you can start taking HSA withdrawals for any reason you choose. If you use the money for something other than health care costs, however, you'll owe federal income tax (and maybe state income tax too). But you won't get hit with the 10% premature withdrawal penalty tax that generally applies to pre-age-65 payouts that are not used for medical expenses. (There's no 10% penalty tax on withdrawals after death or disability either.) This makes the tax rules for withdrawals similar to a deductible IRA.

Alternatively, your HSA balance can be used to cover your post-age-65 healthcare costs including Medicare Part A and B premiums, Medicare HMO premiums, garden-variety health premiums, insurance deductibles and co-payments, prescriptions, long-term care insurance premiums, and so forth. When used to cover health care costs, your withdrawals will be federally tax-free.

If your HSA still has a balance when you depart this cruel orb, your surviving spouse can take over your account federal-income-tax-free and treat it as his or her own HSA. Just make sure to name your spouse as the account beneficiary in the event of your demise.

If You're 55-65 Years Old, You Can Make Bigger Contributions
If you're 55 or older at the end of the year in question, you can make larger deductible HSA contributions than younger folks. The annual contribution maximum that would otherwise apply to you under the rules explained earlier is increased by $600 for 2005; $700 for 2006; $800 for 2007; $900 for 2008; and $1,000 for 2009 and beyond.

Once you turn 65, you can no longer contribute. However, if your HSA still has a balance at that time, you can continue taking tax-free withdrawals for medical expenses or start taxing taxable withdrawals for any reason you choose.

More Eligibility Rules
If you have self-only health coverage for 2005, it cannot require more than $5,100 in annual out-of-pocket payments for covered benefits (including the amount of your policy deductible). For family coverage, the 2005 annual out-of-pocket maximum cannot exceed $10,200 (including your deductible). After 2005, these figures will be adjusted for inflation.

You're ineligible to make HSA contributions for any period when you are covered by a non-high-deductible health plan that provides coverage for any benefits covered under the high-deductible plan (in other words, overlapping coverage with a lower deductible is forbidden). In applying this restriction, however, the following types of health-related coverage don't count:

• Insurance for a specific disease or illness (like cancer insurance).
• Insurance that pays a fixed amount per day or other period of hospitalization (so-called hospital benefit insurance).
• Coverage for accidents, disability, dental care, vision care, or long-term care.
• Workers compensation insurance.

Setting Up an HSA
Legally speaking, an HSA is an IRA-like trust arrangement that can be established at a bank, insurance company, or any other outfit approved by the IRS. Brokerage firms will undoubtedly be players. That said, you'll have to wait and see which ones choose to play, the fees they will charge, and the investment options they will offer. I expect HSAs to be a hit, so we might not have to wait very long.

Right now there's no big hurry because -- like with an IRA -- you'll be allowed to make your 2005 HSA contribution as late as April 17, 2006. So with this set-up, you can contribute to the account after you know how much your annual medical expenses amounted to (although you might want to contribute more than that, if possible, for reasons discussed earlier).