Recently a friend asked me if she should participate in her employer’s Healthcare Savings Account (HSA) or Flexible Spending Account (FSA). Signing up for employee benefits can be very confusing. Especially if you are trying to figure out your 401k, HSA, HDHP, FSA and DSA. What the heck does all of that mean?
In this post we will explore the Healthcare Savings Account (HSA) and the Flexible Spending Account (FSA). These are two of the most common employer-provided savings accounts for healthcare costs. We will talk about how they can save you money, their unique features, and the risks of each type of account. By the end of this post you will have a clearer idea of how to make the decision of whether or not an HSA or FSA is right for you.
It is critical to note, if your spouse signs up for an FSA you cannot fund an HSA that same year! This can get tricky, talk to your financial advisor or CPA for more specific advice.
What do the HSA & FSA have in common?
Both the HSA and FSA allow you to contribute money, pre-tax (!), to an account that can be used to pay for qualified medical expenses. Then you can use that money to pay for qualified medical expenses incurred during the plan year, income tax-free. The list of qualified medical expenses is actually pretty long, and includes co-pays, prescription medicines (+ insulin), medically necessary contact lenses, and hospital expenses for that impromptu ER trip with your 8 year old, etc.
Here is a list of qualified medical expenses for your reference.
Medical expenses that are not covered include (among others) cosmetic surgery, those creepy contacts that change your eye color but don’t require a prescription, health club dues, and, among other items, illegal surgeries. The same link referenced above has a list of excluded items.
HSAs and FSAs Are Easy to Use
Most HSAs and FSAs provide you with a debit card to make using the funds really easy. Generally, an employee commits to setting aside a specified amount of money in the FSA or HSA during annual enrollment. Then the employer divides that amount by the number of paychecks the employee receives throughout the year and reduces their pay (pre-tax) each month to fund the account. That money can be used any time throughout the year for qualified medical expenses incurred by an individual or family member covered by the policy.
For example, if you have an HSA you can use that money to pay for a qualified expense for your own child (who is also covered by your high deductible health plan). Unfortunately, if your niece fell ill you would not be able to use your HSA to help pay her bills. (Unless you claimed her as a dependent on your tax return, but that’s another topic.)
HSA: the benefits and risks
Let’s start with the Healthcare Savings Account (HSA) because more employers are offering these as part of their employee benefits package. You own the HSA. Ownership gives you the the ability to roll-over the money year after year. This means you can invest the money for the long-term, which is a major benefit.
First, if you want to use an HSA you must be pre-Medicare age and covered by a “high deductible healthcare plan.” The IRS defines an HDHP as one where the minimum deductible for a single worker is at least $1,350 or $2,700 for a family (in 2019). Your employer’s healthcare plan may require a higher deductible. In order to qualify for an HSA the maximum out-of-pocket allowed for an individual HDHP in 2019 will be $6,750 and for a family HDHP it's $13,500.
Just because your health plan has a high deductible does not automatically qualify you to use an HSA. The IRS also dictates a maximum limit on the total out-of-pocket expense and annual deductible to qualify as a high-deductible healthcare plan. Find more details here on other requirements for qualification.
**Not all High Deductible Health Plans are eligible for an HSA! Be sure to confirm your health plan's eligibility for an HSA before signing up.**
The good news about an HSA is that an employer can contribute funds to your HSA on your behalf. For 2020 the max contribution (employer + employee) is $3,550 for an individual or $7,100 for a family. There is a $1,000 or higher annual “catch-up” for those age 55 and up. If you and your spouse are both over age 55 you will have to each open your own HSA in order to make two catch-up contributions. Typically your employer will partner with an HSA provider (which is convenient) but you don’t have to use that provider.
There is a significant but often overlooked benefit to having your HSA contributions deducted directly from your paycheck- you avoid payroll taxes on that money. If you make an HSA contribution via payroll deduction you avoid payroll and income taxes. If you make an HSA contribution directly (on your own) you only avoid income taxes. Remember, you always own your HSA. So if you don't like your employer's HSA options, consider rolling the bulk of the money out to your own HSA to invest.
You have until your tax-filing date to make an HSA contribution. If you're just now finding out about HSAs and you qualified to make a contribution for the previous tax year, look into making a contribution before you file your taxes.
There are many HSA providers, be sure to check into what kinds of fees are charged on those accounts. Ask your local bank or credit union or take a look at https://www.hsasearch.com. Your HR department may also serve as a resource for recommendations. It’s also important to note that a High Deductible Health Plan can cover preventative care at no charge. Which means that you won’t have to pay your deductible to get some annual screenings. Read your plan details to find out what your plan covers when it comes to preventative care.
The Downside to an HSA
The biggest risk with an HSA actually revolves around the High Deductible Health Plan (HDHP) you need to be eligible to have an HSA. Consumers can be surprised at the high cost of medical care when they have to pay out of pocket under an HDHP. This leads some consumers to avoid going to the doctor or filling prescriptions. Unfortunately, delaying health care can lead to larger health care expenses down the road.
If you choose to use an HSA and HDHP then you really need to be able to save a fair amount of money in the HSA. So how can you mitigate this risk? All consumers, but HDHP participants and HSA users in particular, would benefit from greater transparency regarding healthcare costs. Let's say you want to sign up for the HSA but have no idea what healthcare ACTUALLY costs - you're not alone. Healthcare Bluebook is a company seeking to bring greater transparency around healthcare costs to consumers. You can use their consumer search option to get an idea of what a doctor's visit "should" cost in your area.
As an example, if you need to take your child to the doctor because you suspect they have strep throat (in the Richmond, VA area) you could expect to pay about $138. Amy Moore, former Senior Vice President at Healthcare Bluebook, has this advice for parents: "Doctor visits don’t vary much, but where your doctor sends you for tests or follow-up care can vary greatly depending on where you go. You can save $100's or even $1000's just by shopping and becoming a smart healthcare consumer."
The Ideal Way to Use an HSA
What’s nice about the HSA is the account belongs to you, so you can roll the money over year after year. In fact, you can actually keep money in this account and use it in retirement. The earnings in the HSA are tax free as long as they remain in the HSA and are used to pay for qualified medical expenses. For example, if you have significant income you could treat an HSA almost like a healthcare IRA. You could invest the funds for the future and just pay your medical expenses out of pocket.
In fact, after age 65 the money in an HSA can be used for anything without penalty. However, even after age 65 if you withdraw money from your HSA for something other than qualified medical expenses you will owe income taxes on the withdrawal. An HSA with it’s triple-tax preference can be an interesting retirement planning tool.
What do I mean by “triple-tax preferenced?” Your income is deposited pre-tax into the HSA, grows tax-free within the HSA, and can be withdrawn tax-free for qualified medical expenses. Be sure to keep good records and check with your tax advisor to see if your expenses qualify.
Should You Choose an HSA?
In reality, most people are not using these accounts as long-term savings. Most people fund HSAs with money for the year and hope their medical expenses are less than what they saved in the HSA. Which brings up a good point - you need to have a higher tolerance for risk to participate in a high deductible health plan in the first place. (I should note, that statement assumes you have a choice in the matter.)
By its very nature, you could end up saving money or spending a lot more money out-of-pocket vs.a traditional health insurance plan. That’s not a judgement one way or the other, it’s simply something to consider. If you are considering using a HDHP and HSA, be sure you can actually set aside your deductible in the HSA. As a reminder, in 2018 the deductible for a single person would have to be at least $1,350 or $2,700 for family. If you can’t afford to set aside the annual deductible in an HSA, then you probably need to look at another plan. Choosing a High Deductible Health Plan to simply save money on monthly premiums is not a good plan.
An HDHP is designed for people who have low medical expenses and can afford to set aside substantial money in an HSA.
FSA: the benefits and risks
The main benefit of an FSA is that you can pair it with a low deductible health insurance plan. In 2019 you are allowed to defer up to $2,700 to a healthcare FSA. Unlike the HSA, you do not technically own your FSA so it has a “use it or lose it feature.” This means that any money you don’t use in a plan year will be lost when the next plan year starts. This rule was a little draconian. In response many employers started allowing employees to roll over a relatively small amount (generally $500 or less) and/or extend the plan year for 2 ½ months. That is at your employer’s discretion so be sure to read your benefits booklet.
Should You Use an FSA?
If you have ongoing medical expenses that are fairly predictable, then an FSA can be a good choice for you. For example, if you wear contact lenses or routinely take a prescription medicine you can pretty easily do the math on how much you spend annually. In turn, that would be the amount you could set aside in your FSA. Personally, we tally up our regular medical expenses and throw in the co-pays for a couple of sick visits (per kid). Due to the "use it or lose it" factor an FSA is not a great way to save for a medical emergency.
What’s the verdict?
Ready for it? It depends. During my husband's company's annual enrollment we compared the High Deductible Health Plan with a low deductible insurance plan. To see whether a HDHP was a good choice for us we ran the numbers. We considered how much we would save in monthly premiums combined with the employer contribution we would receive ($600). In previous years we went with a regular PPO and FSA. In 2019 and for 2020 we selected the HDHP and funding an HSA.
Your situation will, undoubtedly, be different from mine. If you aren’t sure how to decide, consult with your HR rep, tax adviser or a CFP® Practitioner. The FSA is not as flexible as the HSA in terms of rolling over money from year to year. However, it does allow you to pay for some of your qualified medical expenses with pre-tax money without the potential financial risk of using a High Deductible Health Plan.
Feeling nervous about using an FSA? Start with a small amount in the first year and track how quickly you use it up. If you like the FSA you can always contribute more the next year.
* This is not tax advice. Please confer with your tax adviser or financial planner before making any changes.
**The links referenced in this article were deemed reasonable at the time of publishing. We can not make any guarantees as to the accuracy of the information included in those links in the future.