Health savings accounts: Another way to pay for health care

Health savings accounts (HSAs) combined with high-deductible health insurance plans open the door to coverage for those who might otherwise not be able to afford it.

A little history: The HSA was formerly called a Medical Savings Account (MSA) or Archer Medical Savings Account. MSAs ended on Dec. 31, 2003. Starting Jan. 1, 2004, those who would have qualified for an MSA qualified for an HSA. Existing Archer MSAs are still subject to IRS rules.

If you want to open an HSA, it must be paired with a high-deductible health plan (HDHP). With a high-deductible health plan, you pay a cheaper monthly premium and pay for your own preventive care. Your premium savings is combined with the HSA's tax-advantaged account for health care expenses. According to America's Health Insurance Plans (AHIP), a trade group, 6.1 million Americans were covered by HSA plans in January 2008.

According to State Farm Insurance, in 2009, HDHP contribution rates have a minimum annual deductible of $2,000 for individuals and $4,000 for family coverage. The maximum annual deductible is $1,950 ($4,537 for family coverage), with a maximum out-of-pocket expense limit of $4,000 ($7,350 for family coverage).

The "forced" savings in the HSA combined with low premiums for an HDHP are supposed to make health insurance more affordable. The money that you save on premiums can be put in your tax-deductible HSA account and used to pay for medical expenses not covered by the HDHP.

Because HDHPs are not "one size fits all," it's important to shop around for a plan that best covers your family's needs. You'll also want to try to predict your health care use for the coming year: The higher your deductible, the lower your premiums will be. If you don't anticipate using the plan much, you might opt for a very high deductible and take a gamble that you won't need to pay the maximum out of pocket.

To qualify for an HSA:

• You must be covered under a high-deductible health plan.
• You cannot be enrolled in Medicare.
• You cannot be claimed as dependent on someone else's tax return.
• You must be eligible on the first day of the last month of your tax year.

HSA contributions

According to the IRS, you or your employer can contribute money to an HSA throughout the year or by making a lump-sum payment at the beginning of the year.

For an HSA established by a self-employed (or unemployed) individual, the individual can contribute. Family members or any other person may also make contributions on behalf of an eligible individual.

Contributions to an HSA must be made in cash. Contributions of stock or property are not allowed. You can also rollover an MSA to an HSA tax-free if you complete the rollover within 60 days.

Your contributions are 100 percent tax deductible. Any insurance company, bank or similar financial institution is allowed to be a qualified HSA trustee or custodian. If you're purchasing a health plan on your own, your health insurance agent can help you set up an HSA or find a qualified company. For more information about HSA contributions, go to the IRS Web site.

Paying medical costs

Funds in your HSA can be used to pay for "qualified medical expenses," which are expenses that would generally qualify for an IRS medical- or dental-expense deduction. Examples include doctors' fees, prescription and nonprescription medicines, and necessary hospital services not paid for by insurance. Other examples of qualified medical expenses, according to the IRS, include trips to health facilities for treatment, fertility enhancements, artificial limbs, treatment for alcohol and drug addiction, and modifications to your car or home because of a disability or medical condition. For more information about qualified medical expenses, see IRS Publication 502.

You cannot use HSA funds to pay for your HDHP premiums, but they can be used to pay premiums for long-term care insurance, health plan premiums while you receive unemployment benefits, or health continuation coverage premiums (such as COBRA).

You pay your medical expenses by withdrawing money from your HSA account via a "distribution" paid to you by the trustee. A checkbook or a debit card specifically for your HSA may be issued. If you have money left in your HSA at the end of the year, it is carried over to the following year and continues to earn interest.

After you've paid your annual deductible, your health insurance policy kicks in. How much of your medical expenses it pays depends on the type of policy you have. In some cases, your health policy will pay 100 percent of your medical expenses after your deductible. In other cases, you'll have to pay 20 percent of the costs, known as coinsurance, which you can also pay from your HSA.

HSA benefits

Some of the other benefits of an HSA:

• When you pay medical expenses during the year that are not reimbursed by your HDHP, you can ask the trustee of your HSA to send you a distribution from your HSA account to cover those extra expenses.

• You can claim a tax deduction for contributions you, or someone other than your employer, make to your HSA even if you do not itemize deductions on Form 1040.
• Individuals age 55 and older who are covered by an HDHP can make additional catch-up contributions of $900 a year until they enroll in Medicare.
• The contributions remain in your HSA from year to year until you use them.
• An HSA is "portable," so it stays with you if you change employers or leave the work force.

Small employers also benefit by offering HSAs. Small employers that often change health plans every year not only create administrative headaches for themselves but also disrupt their employees' health care. But with HSAs, employers can buy less expensive health insurance policies and may be less inclined to change plans every year.

Since taxes can be deferred, some people use an HSA to build up money for medical expenses in their retirement.

If you are in a 33 percent tax bracket (your annual income is a little over $80,000) and you invested $5,950 each year in a taxable investment that has a 15 percent return on investment, you would have $414,893 after 20 years. If you put your money into a tax-deferred HSA savings account, you would have $798,351 — substantially more.

The IRS has no role in determining your HSA's interest rate; it depends strictly on where you invest your HSA money.

Big penalties for nonmedical withdrawals

What if you don't have large medical expenses and would like to spend your HSA money on something else? What if you want to cash out your HSA to pay for your daughter's wedding, for instance?

You might want to think again. You can withdraw money from your HSA to pay for nonmedical expenses — but it'll cost you. You'll have to pay both income tax and a 10 percent penalty on money you withdraw before you reach age 65. Account holders are also required to retain documentation for their qualified medical expenses.