Is a Health Savings Account Right for You?

Question: My company is offering a high-deductible health-care plan and health-savings account option starting this year. The premiums are much cheaper than they are for the traditional health-care plan (PPO), but I don't want to be penny-wise and pound-foolish.    

Answer: Your question is a timely one. It's benefits-enrollment season at most employers, and one option that's increasingly appearing on employee-benefits menus is a high-deductible health-care plan accompanied by a health-savings account. The percentage of firms offering a high-deductible health-care plan with a savings option increased from 32% in 2010 to 41% in 2011, according to a recent survey by the Kaiser Family Foundation.

HSA Basics
Under a high-deductible health-care plan, individuals are required to pay the first several thousand dollars in medical expenses out-of-pocket. (Preventive services are often available without a deductible.) Insurance kicks in after that, often paying 80% of the bills with the employee shouldering the other 20% of costs until the individual or family hits the out-of-pocket maximum for the year. In exchange for the risk that you'll be on the hook for the high deductible and coinsurance amount, the premiums on high-deductible health insurance plans are usually quite low.

In addition, if you're contributing to what the IRS considers a high-deductible plan (you have a $1,200 deductible for single-only coverage or $2,400 for family coverage in 2011), you can contribute to a health-savings account. In turn, you can use the funds in your HSA to cover medical expenses. The HSA enjoys some valuable tax benefits, too. If you're contributing to an HSA because you have a high-deductible plan through your employer, your contributions may be pretax; if your employer makes a contribution on your behalf, that amount isn't taxable, either. If you're contributing to an HSA on your own, your contributions will be deductible, above the line, on your tax return, even if you don't itemize your deductions.

Distributions from your HSA are tax-free, provided you use them to pay for qualified medical expenses, and earnings on the investments you hold within your HSA compound from year to year on a tax-free basis. (In contrast with "use it or lose it" flexible spending accounts, any unused amounts in your HSA can be carried over into future years.) After age 65, you can withdraw the money without penalty and use it on non-medical expenses, though you'll have to pay income taxes on your withdrawals. (Younger individuals who tap their HSAs for non-medical expenses will owe both income taxes and a 20% penalty.)

You can invest the HSA assets in a whole gamut of investment vehicles, including mutual funds. In many respects, the HSA is quite similar to a traditional nondeductible IRA and provides another tax-deferred savings vehicle for those who have maxed out their other options. There are no income limitations. Those with a single plan can contribute $3,050 to an HSA in 2011 ($4,050 if you're over age 55), whereas those with high-deductible family plans can contribute $6,150 in 2011 ($7,150 if you're over 55). (Those amounts increase to $3,100/$4,100 for 2012 for individuals and $6,250/$7,250 for families.) You cannot contribute to an HSA if you're covered by Medicare or most other health-care plans, such as a spouse's plan. IRS Publication 969 describes HSAs in detail.

Who Can Benefit
You sometimes hear that high-deductible plans, combined with HSAs, are the best fit for "the healthy, the wealthy, and the young," and that's not too far off. If you're healthy, you may not incur much in the way of out-of-pocket health-care costs; given that your premiums are lower with a high-deductible plan than they are for traditional coverage, you may come out ahead. Moreover, wealthy households will be in the best position to pay high out-of-pocket health-care costs, if they should arise, without having to up-end their households' financial plans.

And if you build up your HSA and don't need to spend the assets, your contributions will roll over from year to year (in contrast with a flexible spending account, or FSA). The compounding of returns and tax benefits will tend to be especially beneficial if you're wealthy and you start contributing when you're young. An HSA can be a good fit for an individual or couple who is maxing out other tax-sheltered options like their 401(k)s and IRAs; because the money can be withdrawn without strictures after age 65, such people can think of the HSA as a supplemental retirement savings vehicle.

Finally, as with flexible spending accounts, HSAs can be used to cover expenses not covered under many traditional health-care plans, including eye care, dental care, and qualified long-term care services. As with flexible spending accounts, however, you can't use your HSA to pay for over-the counter drugs, unless it's insulin or you get a prescription for it

Who Should Steer Clear
First and foremost, a high-deductible plan can be costly if you have a chronic medical condition or make frequent doctor's visits beyond basic preventive care; your out-of-pocket costs can quickly exceed any savings you receive via lower premiums. 

Opting for the high-deductible plan is also a bad idea if you don't typically have extra liquid savings available to help you cover out-of-pocket expenses that might arise; if you often find yourself living paycheck to paycheck, then steer clear. Even if you can fund your HSA to the maximum allowable level, there could be a big gulf between what you've saved there and the amount you'll be required to pay before you hit your plan's ceiling on out-of-pocket costs.

Needless to say, such plans are also a bad idea if you don't have the discipline to fund your HSA, because you'll have to invade other pools of cash, such as your savings or emergency fund (or worse) to pay out-of-pocket costs. Finally, the tax benefits of an HSA will be less important if you're not funding your 401(k) or IRA to the maximum allowable levels.