By Lauren Klein
Learn more about Lauren on NerdWallet’s Ask an Advisor
Planning and saving for health care is an essential part of your overall retirement-planning process. One way to do that is by opening a health savings account.
A health savings account, or HSA, is an account that can be used along with a high-deductible health insurance plan. Funds within the HSA can be used for covering medical expenses that are not covered by the insurance policy, such as vision and dental procedures.
The need for such planning is clear. Retirees and those who are approaching retirement will face major challenges in managing future health-care costs due to improving longevity, rising medical costs, declining employer medical coverage, and a possible funding crisis for Medicare and Medicaid, according to insurance research firm LIMRA. Health savings accounts can save you money and help you manage your health-care needs.
Benefits of health savings accounts
Health savings accounts have numerous advantages. For example, the contributions that are made to the account are tax-deductible, even if the account holder does not itemize their deductions.
In addition, once in the account, the funds are allowed to grow completely tax-free. Certain withdrawals from the HSA are also allowed to come out on a tax-free basis, provided that they are for qualified medical expenses.
Other HSA advantages include:
- Employer contributions: If an HSA is part of an employee benefits plan, employers are allowed to make contributions into the account for the benefit of their employees.
- No “use it or lose it” provision: Money can remain in a health savings account until it is eventually needed.
- Portability: HSA accounts are also portable, so even if an individual changes their workplace, the account may be taken with them.
Qualifications for opening an HSA
In order to open a health savings account, certain qualifications must be met. First, an individual or family must be enrolled in a high-deductible health insurance plan as of the first day of the month. (You are considered to be an eligible individual for the entire year if you are eligible on the first day of the last month of your tax year, which for most people is Dec. 1.)
In 2015, a high deductible health insurance plan is considered to have the following minimum deductibles and maximum out-of-pocket costs: For an individual, the minimum deductible is $1,300 and the maximum out-of-pocket is $6,450; for a family, the minimum deductible is $2,600 and the maximum out-of-pocket is $12,900.
In addition, you cannot be claimed as a dependent on another individual’s tax return. You also must not be enrolled in other health insurance — including Medicare — as that is not considered to be high deductible health insurance coverage.
Making HSA contributions
Once you are eligible to participate in a health savings account, you can start making contributions. In an employer-sponsored HSA, both an employee and their employer may contribute to the plan. Family members or any other person may also make contributions on behalf of an eligible participant.
There are, however, maximum caps on the contributions that can be made each year. It is important not to exceed the amount of annual contribution, as excess amounts can incur a 6% excise tax.
For 2015, the contribution limits for health savings accounts are as follows: for individuals, a contribution limit of $3,350, with an additional $1,000 allowed past the age of 55; and for a family, a contribution limit of $6,650, also with the additional age-55-plus allowance.
It is important that the contributions that are made each year are fully reported for tax purposes. This includes those that are made by April 15 of the following year. Contributions are reported on IRS Form 8889 and are filed along with Form 1040.
Reporting HSA distributions
In many cases, individuals will pay medical expenses throughout the year without being reimbursed by their high deductible medical plan — until they reach the annual deductible in the plan. When you pay medical expenses that are not reimbursed by the health insurance plan, you can ask the trustee of the HSA to send you a distribution.
Regardless of how you use the distribution from your HSA, it is required that you report each of your plan distributions on IRS Form 8889 for tax purposes. (This is the same IRS form that is used for reporting your annual HSA contributions.)
Some of the distributions that you use may count as qualified medical expenses, whereas some may not. When reporting the distributions from a health savings account, the distributions will need to be reported either as a qualified medical expense or as a non-qualified medical expense.
Typically, some of the procedures that will fit the criteria as qualified medical expenses include the following:
- birth control pills
- breast pumps and supplies
- contact lenses and eye glasses
- dental treatments
- disabled dependent care
- fertility enhancement
- hearing aids
- home health care
- legal fees
- long-term care premiums
- nursing home
- psychiatric care
- stop-smoking programs
- vision-correcting surgery
- weight-loss programs
Any non-qualified medical expenses will be subject to normal income tax. They may also potentially be subject to an additional 20% IRS penalty if they are taken out by HSA account holders who are under the age of 65. If, however, you are age 65 or over and you take distributions from an HSA, you will only be subject to paying income tax on the funds.
Some examples of non-qualified medical expenses include non-prescription medications other than insulin. In addition, insurance premiums are also considered to be non-qualified, unless the premiums are for certain types of coverage, such as:
- Long-term care insurance
- Health care continuation coverage (COBRA)
- Health care coverage while receiving unemployment compensation under federal or state law
- Medicare and other health-care coverage if you were age 65 or older (other than premiums for a Medicare supplement insurance policy)
What happens to a health savings account after you die?
If you die while you’re still the owner of the account, but named your spouse as the beneficiary, then the HSA will be treated as your beneficiary’s HSA account going forward.
However, if you don’t name your spouse as the beneficiary, then the account will be considered taxable at fair market value to the beneficiary in the year in which you die. The account also stops being an HSA.
The bottom line on health savings accounts
Today, there is a great deal of change occurring in the health care environment; unfortunately, such change can come with higher expenses for many retirees. Because health care is such a high — and growing — cost for so many retirees, a health savings account can make a lot of sense to help with these uncovered medical costs.