HSA accounts: The good news and bad news

If you don’t know what a health savings account is, it’s time to find out.

These accounts, which are available only to people who have a high-deductible health plan, offer a trifecta of tax benefits for people who use them to save money for medical expenses: you put money in pre-tax, the money grows tax-free and is distributed tax-free as long as you use it on qualified medical expenses. But for many people, the disadvantages of such plans will outweigh the advantages.

A key tenet of President-elect Donald Trump’s stated health-care plan is to expand access to these savings accounts, but there’s already a growing trend among employers to move employees to high-deductible insurance plans. That means consumers need to understand both those insurance plans and the pros and cons of health savings accounts.

Here’s why: A trend toward high-deductible health plans spells trouble for many people’s financial and health outlook — unlike a traditional insurance plan, a high-deductible plan necessitates having money set aside for initial health costs — but it’s also true that some retirement savers are going to like what they see with health savings accounts.

That’s because they are probably the most tax-beneficial account on the planet and, for those who have good health, good luck and the financial wherewithal to pay their health costs out of pocket while they work, a health savings account or HSA could be a stellar way to save for that huge health-care bill we’re all going to face in retirement.

You’ve seen the numbers, right? One estimate is that a 65-year-old couple retiring in 2016 will need $260,000, or about $13,000 per year for 20 years, according to Fidelity Investment data.

With an HSA, you contribute pre-tax money, like a 401(k) or other defined-contribution account. You invest the money, and it grows tax-free. The icing on the cake is that if you use the money for qualified medical expenses, you don’t owe any tax on that money at all. Ever.

“One of the major benefits of the HSA is the tax-deferred growth and tax-free distributions if proceeds are used for qualified medical expenses,” said Brent Ulreich, senior financial planner at Hefren-Tillotson Inc. in Pittsburgh, Penn. “Even after you leave employment, funds left in your HSA can be used to pay for medical expenses throughout retirement.”

But there are drawbacks. One major hitch is that to open an HSA, your health insurance plan must have a high deductible. In 2017, only health plans with a deductible of at least $1,300, for single people, or at least $2,600 for family coverage, qualify.

Given that only 37% of folks said they can afford to pay for a $1,000 emergency from their savings account (that’s from a 2016 Bankrate survey) the question is how many people are financially prepared to pay for the health expenses they face under a high-deductible plan?

High-deductible plans generally have lower premiums than traditional plans, but people who use such plans need to consistently stash the difference into an HSA. These accounts only benefit people who are disciplined about saving, or have enough monthly cash flow to cover their health costs.

Meanwhile, the long-term tax benefits of HSAs — letting that tax-free money grow tax-free — will only accrue to you if you don’t need to withdraw the money. That is, these plans are a huge boon to those who can afford to pay for medical expenses with cash on hand, letting the money in these accounts grow.

A study in 2006 by the U.S. Government Accountability Office (GAO) found that about 55% of the people who reported HSA contributions in 2004 didn’t withdraw any funds from their account that year. The study also found that HSA users had higher-than-average incomes, with 51% earning adjusted gross income of $75,000 or more, versus 18% of all taxpayers under age 65. “Many focus group participants reported using their HSA as a tax-advantaged savings vehicle, accumulating HSA funds for future use,” the study said. One focus group participant said he paid for an expensive surgery out of pocket, so he could save his HSA money for the future. (Granted, HSAs didn’t become available until 2004, so this report is an early indicator of HSA use.) Read the report

Moving toward high deductibles

The move seems to be toward such plans. Certainly, Trump’s health plan includes expanding access to HSAs and making such accounts inheritable.

Read more: Health savings accounts are crown jewel of ‘Trump care’

HSAs have long been favored by Republicans, in part because such plans are said to encourage smarter consumer behavior. Rather than almost all costs being covered by your insurer, you have those upfront costs to pay before the deductible kicks in. The thinking, at least in part, is that will encourage consumers to shop around. (Some studies suggest it encourages people to refrain from seeking care at all.)

But it turns out one aspect of the Democratic push toward Obamacare might also be encouraging employers to move toward high-deductible plans: the so-called Cadillac tax, which, if it goes into effect, will tax the value, over a specified amount, of the most generous health plans. That tax is slated to go into effect in 2020, though with the new Republican administration there seems to be a good chance it will be repealed. Under the Obama administration, employers were eyeing ways to avoid that tax by reducing the value over their plans, in part by shifting to high-deductible plans, according to a study by Richard L. Kaplan, a law professor at the University of Illinois. The full study is here

Cadillac tax or not, companies in general want to lower their health costs. A growing number of U.S. workers are covered by a high-deductible health plan paired with an HSA: 19% of workers who have employer-sponsored health insurance have that type of coverage in 2016, up from 15% in 2015, according to the Kaiser Family Foundation. Read their report.

Plan deductibles vary widely, but the average for workers who have a high-deductible plan combined with an HSA is higher even than the regulations call for: $2,295 for single workers and $4,364 for family coverage, according to the Kaiser Family Foundation.

Not all bad

High-deductible plans combined with HSAs do offer some consumer protections and benefits. For example:

• People with high-deductible plans are legally protected in terms of their maximum out-of-pocket expense for deductibles and copays. In 2017, that maximum is $6,550 for individuals and $13,100 for family coverage in 2017.

• Thanks to the Affordable Care Act, some preventive care—including some cancer screenings—are covered before that high deductible kicks in.

• The money you save in your HSA can be accumulated over time, unlike a flexible savings account that requires you to spend the money down each year.

• Your employer might offer matching contributions, like a 401(k).

• If you manage to save the money for retirement (that is, you don’t need to use it for medical costs before you retire), HSA accounts don’t require distributions the way that traditional IRAs do at age 70-1/2. And Trump has suggested HSAs should be inheritable.

Not all good, either

There are also some serious drawbacks. Here’s one: If you use your HSA savings for non-qualified expenses before age 65, “you’ll owe an additional 20% penalty in addition to any taxes due,” Ulreich said.

Generally, qualified expenses for HSAs are the same as those for claiming the medical expense deduction. Some examples of nonqualified costs include “unnecessary” plastic surgery, swimming or dancing lessons even if recommended by a doctor, most insurance premiums, diaper service, hair transplants, and electrolysis. See IRS Publication 502 for the complete list and Publication 969 for general rules on HSAs.

A health savings account “should always be viewed first as a savings and accumulation vehicle for the inevitability of medical emergencies, but it does offer an opportunity for an additional retirement savings strategy,” he said.

Another drawback is that the investment options in your HSA may be limited and more expensive than your 401(k). “I would say the investment options in general are not as good as what you’re going to see in a 401(k),” said Rob Austin, director of retirement research at consulting firm Aon Hewitt. “HSAs are a relatively new concept and don’t have the same assets under management,” he said.

As for allocating your perhaps limited paycheck to an HSA instead of your 401(k), be wary. In addition to cheaper and more robust investment options, your 401(k) may come with a better employer match. “Most people should probably look at [an HSA] as a complement to their 401(k) strategy if they’re looking at this as a long-term investment vehicle, and not so much as a replacement for it,” Austin said.

If you can swing it, do both, said Marina Edwards, senior retirement consultant at consulting firm Willis Towers Watson. “It could be a good strategy to save enough into your 401(k) to get the matching contributions and then allocate your additional leftover savings dollars to your HSA.”

Manage your money

With a high-deductible health plan, don’t set it and forget it. While the low premiums might be appealing, be sure to pay the difference (between those premiums and a typical health plan) into an HSA.

“The mindset when you’re going through open enrollment is, ‘Oh, this is a great deal. I’m going to pay less per paycheck,’” said Eric Dowley, head of Fidelity Investments’ HSA business. “Then they forget about it and then it’s, ‘Oh my gosh. I have to pay this.’”

Look at the difference in premiums between an HMO or PPO and a high-deductible plan. If you’re willing to pay $400 a pay period for the HMO but you’re paying $200 a pay period for the high-deductible plan, set that $200 monthly savings into a health-savings account, Dowley suggested.

If you’re lucky in health, or wealthy enough to cover your health expenses out of pocket, you can let the money grow in your account tax-free—awaiting your retirement. “To the extent that you can devote some money and set it aside for medical expenses that are going to take place in your golden years,” said Aon Hewitt’s Austin, “by all means go ahead and do that.”

But don’t embrace one of these plans at the cost of your health.