How Health Savings Accounts Work: An Interview with John Phillips

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In 2003, a Medicare bill introduced Health Savings Accounts to help people save tax-free money for future medical and health expenses. Recently, John Phillips, Executive Director of the Group Insurance Trust of the California Society of CPAs, took time to answer a few questions about Health Savings Accounts and how they work.

What Is a Health Savings Account?

Health Savings Accounts, in the way this term is normally used, have two parts. The first part is a health insurance policy with a minimum deductible of $1,000 (self-only coverage) or $2,000 (family coverage). In addition the policy must include maximum annual out-of-pocket expenditure limits. The second part of the Health Savings Account is an investment account from which you can withdraw money tax-free for medical care. Monies in the account that you do not use to pay medical expenses accumulate with tax-free interest until they are withdrawn. Once you reach age 65 you can withdraw them for any purpose and pay normal income taxes on amounts not used for medical purposes.

Who Is Eligible for an HSA?

To be eligible for a Health Savings Account, an individual must be covered by a High Deductible Health Plan (HDHP), must not be covered by other health insurance (however, this limitation does not apply to specific injury insurance and accident, disability, dental care, vision care, and long-term care insurance), is not eligible for Medicare, and can't be claimed as a dependent on someone else's tax return. No permission or authorization from the IRS is necessary to establish an HSA.

Opening a Health Savings Account

Many insurers will offer you a qualifying high deductible insurance policy and a linked Health Savings Account so you will not have to find and open a separate HSA account. Other insurers offer just the qualifying high deductible insurance policy, and you will have to find a bank or other trustee to open your Health Savings Account. In selecting your HSA account, be sure to identify the related charges and fees as these can vary widely.

Determining the Annual Contributions

The maximum annual amount that an individual (or his/her employer) can contribute to his/her HSA account for a full year of plan participation is the lesser of the plan's deductible or $2,600 (for 2006). For a family, the maximum contribution is the lesser of the plan's deductible or $5,150 (for 2006). Because in most cases the amount contributed will be tax-deductible, the earnings on monies held in the account will accumulate without current taxation and the amounts withdrawn will be applied toward IRS approved medical expenses, contributions into an HSA account enjoy a significant tax subsidy. Consequently, you should contribute annually (to the extent of your ability) the full amount that is currently deductible.

Withdrawing Funds

You may withdraw money from your HSA account at any time. Distributions from an HSA used exclusively to pay for your qualified medical expenses or those of your spouse, or dependents, are excludable from gross income. However, any amount of the distribution not used exclusively to pay for qualified medical expenses of you, your spouse or your dependents is includable in your gross income and is subject to an additional 10% tax on the amount includable, except in the case of distributions made after your death, disability, or attainment of age 65.

Difference Between HSA and FSA

Some employers offer coverage under a flexible spending account (FSA) that provides medical benefits to eligible employees. In general, you cannot be covered under both an HSA account and a FSA account providing medical benefits. The rules governing when these two types of accounts may be used at the same time are complicated and, if you find yourself in this situation, you are encouraged to seek assistance from your insurance advisor.

Advantages of Health Savings Accounts

HSA accounts have both the ability to substantially reduce your insurance premiums (because you bear more risk) and, if both you and your family are relatively young and healthy, the ability to allow you to accumulate a significant pool of before-tax monies to pay current and future medical expenses. However, you bear some risk in the early years after adopting an HSA should you quickly incur significant medical expenses not paid for by the plan before you have had an opportunity to build an HSA account protective financial cushion. On balance, HSAs provide a superior combination of encouraging you to shop prudently for medical services (because, for the most part, you are spending your own money) while retaining insurance protection for catastrophic claims.

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How Health Savings Accounts Work: An Interview with John Phillips