Healthcare Savings Accounts: HSA and FSA

Healthcare Savings Accounts: HSA and FSA

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It has become increasingly essential that we put aside money each year to save for healthcare. Today, we’ll go through two of the most popular tax-deductible healthcare plans: the HSA and FSA.

Benefits of a Tax-deductible Healthcare Account

Healthcare is an essential component of being able to live a worry-free life, as they can help cover most daily medical expenses and pay for unexpected accidents. With so many plans available to cover your healthcare costs, it is ideal to pick a tax-deductible option. What does tax-deductible mean? Tax-deductible is earnings that are exempt from your annual taxable income. If you allocate money to a tax-deductible healthcare plan, then these funds will not be taxed.

For example, Jim earns $100,000 annually (pre-tax) and is taxed at 25 percent. He would be taxed on all of his money, leaving him with $75,000 after taxes. If Jim placed $10,000 into a tax-deductible healthcare plan, and was taxed at the same 25 percent, then he would only be taxed on $90,000 of his money. The $10,000 he had put away before is now off-limits to taxation. He’s now left with $67,500 of post-tax money along with the $10,000 designated for healthcare costs. This totals $77,500, which is more than if he hadn’t put his money in a tax-deductible account. Tax-deductible accounts and plans are always ideal because less of your hard-earned money is taken away for tax purposes.

HSA

Let’s start off with one of the most common plans: the HSA. The Healthcare Savings Account (HSA) is exactly what it seems to be. The HSA is a tax-deductible savings plan for preventative healthcare costs. However, you need an HDHP to open a HSA.

An HDHP (High-deductible health plan) is a more affordable healthcare plan that compensates for high deductibles for low monthly insurance costs. Health insurance deductibles are essentially the minimum amount you have to pay for healthcare costs before your insurance kicks in. You can learn more about HDHPs here. Tip: you always want to avoid high deductibles, as that just means you have to pay more money out-of-pocket.

You can open an HSA independently or through a bank, healthcare provider, or employer (depending on employer policy). Certain major brokerage firms such as Charles Schwab and Fidelity also offer the HSA to clients. If your employer offers an HSA, they can match you by your contributed amount, similar to a 401(k). The max contribution in 2020 to a HSA is $3,550 (independent) and $7,100 for a family plan ($3,550 per spouse). Any amount not spent will automatically roll over to the next year. This is an essential benefit of the HSA because there is potential for long-term savings. 

The second advantage of the HSA is that it allows you to invest your contributions through mutual funds and other investment options completely tax-free. This tax-free contribution policy is quite similar to the Roth IRA retirement account. You can grow your principal at various rates by carefully selecting your investments inside the HSA. There are no state or federal taxes during deposit or withdrawal. As a result, investment gains in an HSA are tax-free. Money withdrawn from an HSA must be used for medical or healthcare expenses. This means not only is your original deposit not taxable, but so are any gains you make using that initial deposit (if used for qualifying medical expenses).

Using the HSA

Unfortunately, withdrawing from an HSA for a non-medical expense will elicit a hefty 20 percent tax. This doesn’t include the additional state and federal taxes you’ll incur. An HSA is a beneficial savings plan for individuals and families who already have an HDHP and whose healthcare costs exceed that of their current plan or anybody who tends to accumulate significant medical expenses and needs a reliable backup fund. The HSA covers IRS-certified healthcare expenses such as prescription drugs, vision and dental costs, and capital expenses.

Capital expenses are any expense you take on (usually in a business scenario) to benefit from and upgrade a certain asset such as property. In the case of the HSA, an example of a qualifying capital expense would be if you installed a wheelchair ramp on the outside of your home if you or any of your family members are disabled.

FSA

The second tax-advantaged healthcare account is the Flexible Spending Account (FSA). The FSA is another tax-deductible account that provides users a wide selection of uses for out-of-pocket healthcare costs, including prescription medications, dental and orthodontic treatment, and other medical expenses. 

The FSA is an employer-sponsored healthcare account. Money is taken from your paycheck and deposited into the FSA. The annual cap for the FSA is $2,750 per person in 2020. In a family, as long as both the employers of both spouses offer the FSA, their contributions would max out at $5,500 per year. 

The FSA is lacking in terms of rollover and investable assets,. The FSA is seen as a supplementary account to help pay for out-of-pocket expenses. Money deposited into an FSA can’t be invested. FSA funds are beneficial because they are tax-deductible, but they can only be used for a health-related expense (this term is defined loosely, but we will cover some of these expenses later on). Out-of-pocket costs are expenses that your insurance fails to cover (the amount for you to pay before or after your insurance has kicked in). 

FSA Rollover Situations

The FSA doesn’t automatically rollover your yearly deposits to the next year. There are three situations regarding yearly rollover:

  1. In the first situation, the employer can allow their employee to rollover up to $500 of their FSA funds, which enables the employee to save the $500 of the current year’s unused funds for next year. If there’s more than $500 left in the account by the end of the year, you lose the excess.
  2. In the second situation, your employer does not choose the $500 annual rollover, but insteads implements the grace period, an extra two and a half months in addition to the calendar year to spend any leftover FSA funds, totaling fourteen and a half months as opposed to just twelve.
  3. In the third situation, your employer chooses neither of these options. The excess funds are gone at the end of the year.

Although $2,750 may seem like an excess amount to spend on just healthcare costs, extra funds can be very flexibly utilized for certain qualifying additional expenses. You can use unspent FSA funds for health-related benefits such as acupuncture and birth control. The IRS has more details about HSA and FSA coverage. It’s also possible that you could end up rapidly spending all of your FSA money. Healthcare costs can add up very quickly, especially if you have daily or monthly recurring expenses such as prescription medications. 

Making a Choice: HSA vs FSA

It might seem like the HSA is the superior option to the FSA due to its more generous rollover policy and the ability to grow as investable assets. However, the HSA also has one major drawback: the requirement of the High-Deductible Healthcare Plan (HDHP). In order to qualify for an HSA, you must already have high-deductible insurance. As mentioned above, HDHPs are not the most desirable as the high-deductibles mean you have to pay more out-of-pocket.

While you can’t invest funds in an FSA and they lack a definite rollover policy, it can be utilized by anyone. If you have the opportunity to open an FSA, you should because of its flexibility and tax advantages. If you do have an HSA, you can also open an FSA to use them together given that your employer offers this option. Although the HSA and FSA are both tax-deductible plans, using them concurrently can further cut down healthcare costs. 

Key Takeaways

  • The HSA has a limit of $3,550 per person while the FSA has a limit of $2,750 per person. Both accounts cover the same medical expenses.
  • The HSA is most beneficial for individuals and families who don’t have or can’t afford more premium insurance. It’s also great for people with a pre-existing HDHP.
  • The FSA is a great choice for anybody hoping to cut down on healthcare expenses by opening a tax-deductible account
  • You can use both accounts for increased health cost savings. However, your employer must offer an FSA and you need an HDHP.

The Bottom Line

As the US tries to control COVID-19, consumers are looking for ways to decrease their healthcare costs. By utilizing tax-deductible accounts to help cover their healthcare costs, consumers can improve their financial awareness and prepare for emergencies. These healthcare accounts help consumers keep more of their income, which allows them to utilize their profits for other investments. As healthcare becomes increasingly expensive, every tax advantage can help you keep more income for your own well-being.

About the author

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I'm a junior at Amador Valley High School, and I enjoy writing and learning about financial literacy!