Health Savings Account (HSA) Basics

Most of us like to take advantage of every available tax break. So, if you are eligible for a Health Savings Account (HSA), now might be a good time to start one. HSAs operate somewhat like the flexible spending accounts (FSAs) that some employers currently offer their employees who want to defer a portion of their pay on a pretax basis to be used later to reimburse themselves for out-of-pocket medical expenses. Unlike an FSA, however, whatever’s left in the HSA at year-end can be carried over to the next year. In addition, HSAs can be set up by the self-employed or even a nonworking spouse.

Naturally, there are a few catches. The most significant requirement is that HSAs are only available to individuals who carry health insurance coverage with relatively high annual deductibles. By that, we mean their health insurance coverage must come with at least a $1,100 deductible for single coverage or $2,200 for family coverage. However, for many self-employed individuals, small business owners, and employees of smaller companies, these thresholds won’t be a problem. In addition, it’s OK if the insurance plan doesn’t impose any deductible for preventive care (such as annual checkups).

The other requirements for setting up an HSA are that an individual can’t be eligible for Medicare benefits or claimed as a dependent on another person’s tax return. Individuals who can meet these requirements can make tax deductible HSA contributions for 2008 of up to $2,900 for single coverage or up to $5,800 for family coverage. When an employer contributes to an employee’s HSA, such as in the case of a closely held business, the contributions are exempt from federal income, social security, Medicare, and FUTA taxes.

An account beneficiary, who is age 55 or older by the end of the tax year for which the HSA contribution is made, may make a larger deductible contribution. Specifically, the annual contribution limit is increased by $900 for 2008.

An HSA generally can be set up at a bank, an insurance company, or any other institution the IRS deems suitable. The HSA must be established exclusively for the purpose of paying the account beneficiary’s qualified medical expenses. These include uninsured medical costs incurred for the account beneficiary, spouse, and dependents. However, for HSA purposes, health insurance premiums don’t qualify; neither do higher deductibles or higher out-of-pocket maximums for out-of-network benefits.

The tax rules for HSAs are quite similar to those for IRAs. For example, individuals can make HSA contributions for a particular tax year as late as April 15 of the following year. In addition, federal-income-tax-free rollovers from one HSA into another are permitted (but only once per 12-month period).

HSAs seem like a match made in heaven for those currently paying health care costs out of their own pocket using after-tax dollars. Provided you have (or are willing to change to) health insurance coverage that qualifies as a high-deductible policy, there doesn’t seem to be a downside to setting up an HSA, because unused amounts at year-end carry over to later years. Setting up an HSA should allow you to pay your medical expenses with pretax dollars. For example, for those in the 28% tax bracket, this is like getting a 28% discount on their medical expenses. For business owners who are covered by health insurance through the company, having the company fund the HSA can make sense.

This is just a quick overview of the HSA rules. Please call us if you’d like to know more about whether an HSA is right for you or to discuss any other tax compliance or planning issue.