Using Health Savings Accounts strategically

Nothing’s more dull than insurance, unless you don’t have it when you need it. Health Savings Accounts (HSAs) are a relatively unknown way to acquire health insurance. Cheap, tax advantaged, and great for business owners and the self employed, HSAs can make health insurance affordable again.

In brief, first you find a high deductible health insurance policy (either with your employer or on your own if you’re the employer or self-employed). Because these are high deductible, they are often quite affordable compared to traditional policies. Then, you establish an HSA savings account with a bank,  brokerage, mutual fund or other trustee, and deposit the maximum in the account: $3,050 per person covered if you or they are under 50, $4,050 if over 50. Under normal procedures, you then either use a debit card, write checks on the account, or submit bills for payment (depending on how your account provider works), up to the amount of your expenses until you reach your deductible. Once the deductible is reached, your health insurance provider covers the rest according to the co-insurance you’ve chosen. In most cases I recommend choosing a low deductible (say, $1,200 or $1,750) with 100% coverage after that, but this requires a careful look at your individual circumstances and the plans you are considering.

The beauty of HSAs is that you get to deduct the whole contribution each year EVEN IF your medical expenses are lower than your contribution. Without an HSA you can normally deduct medical expenses only after they exceed 7.5% of your income, which is some pretty big bill for many people. But with an HSA, you can spend $150 for doctors’ bills and still deduct $3,000. I like that.

Second nifty point is that not only do you get a deduction going in, but it’s tax-free coming out, as long as you use it for medical bills. Now, here’s where the strategy comes in. You don’t have to make withdrawals in the year you incur the bills. So, if you can afford to pay the bills out-of-pocket and can do a decent job of keeping careful records, you can wait until 65 to take disbursements. As long as the disbursements are for medical bills (current or previously incurred), they are tax free. So, you could accumulate bills and submit them once you retire, as you need cash.

What if you don’t keep such good records? The money can still be withdrawn after 65, but you’ll have to pay ordinary income tax if you don’t use it for medical bills. It can be a nice little account to pay for long term care insurance, prescriptions not covered by Part D, dentistry, or anything not covered by Medicare. Given all the saber rattling in Congress about reducing Medicare benefits, it might not be such a bad idea to have a health savings account in reserve.

Let’s just look at some numbers. Say you’re 50 years old, you establish an HSA and keep it going for the next 15 years. Say also that interest rates stay pretty junky for that whole period (unlikely) and you only make 4% a year with 3% inflation. When you start collecting Medicare you’ll have about $65,000 in that account, and potentially much more if you can cover a spouse or children (the account holder keeps the money even after the children “age out”). Withdraw $3,000 a year to cover, say, long term care insurance and it’ll last for about 25 years. Or take larger withdrawals and let your other portfolio(s) grow. Again, it requires some individual planning, but it’s not such a bad thing to have an extra $65,000 for tax free income.

The gap between your deductible and what you can save is just such a good deal I’m surprised it hasn’t been targeted for budget cutting measures. Maybe it’s because, so far, so few people use it. Save the whole thing and enjoy the deduction and tax-free compounding. Be one of the smart ones.

Caveat: there are a lot of details on this. There’s an IRS publication 969 that sets out all the rules, but I’d be happy to talk over HSAs with you at any time.