Getting a policy that qualifies for an HSA can be a great move. Image source: Pictures of Money via Flickr.
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In saving for retirement, investors typically have to make a choice. A traditional IRA offers an upfront tax break but comes at the price of paying tax when you withdraw money in retirement. A Roth IRA gives you tax-free treatment in retirement, but you don't get a deduction when you make a contribution. Yet there's a third type of account that's not even meant to be a retirement savings vehicle that nevertheless offers the best of both worlds: an upfront tax deduction and tax-free treatment when you use the money. That account is a health savings account or HSA, and increasingly, people are realizing the unique opportunity for this ideal tax saver.
What a health savings account is
Health savings accounts are tax-favored accounts that you set up with a financial institution in order to pay for certain medical expenses or to reimburse you for the money you spend on those medical expenses. The government created HSAs in 2003 so that individuals who were covered by a certain type of health insurance policy would be able to get tax-favored treatment for the money they set aside to help them cover their healthcare expenses.
The key aspect of an HSA is that you have to have what's known as a high-deductible health plan as your primary insurance coverage. High-deductible health plans, or HDHPs, have higher annual deductibles than typical health plans, and they also have a maximum limit on the deductible and other out-of-pocket medical expenses that you have to pay. For 2016, the minimum deductible necessary for a policy to qualify as an HDHP is $1,300 for individual coverage or $2,600 for family coverage. Maximum out-of-pocket amounts are $6,550 and $13,100, respectively, for individual or family policies.
Why health savings accounts are a great tax break
The best thing about HSAs from a tax perspective is that you are eligible to deduct the money that you contribute toward the account. For 2016, those with individual coverage can contribute up to $3,350 to an HSA, and family coverage has a higher $6,750 contribution limit. In addition, employers are allowed to make contributions to an HSA on your behalf as well. If they do, then the money they contribute is not treated as income.
Yet even after you get that upfront tax deduction on your contributions, HSAs thereafter closely resemble Roth IRAs in their favorable tax treatment. Interest and other earnings on assets within the HSA aren't subject to tax. Most important, when you take distributions out of the HSA to cover qualified medical expenses, you don't have to pay any tax on the withdrawn amounts.
The list of qualified medical expenses is extensive, matching up with the definition that the IRS uses in determining whether you can take an itemized deduction for certain medical and dental costs. You can get details at this IRS website, but everything from routine doctor visits, prescription costs, and annual physical exams to hospital services, nursing home expenses, and surgical procedures typically qualifies for favorable treatment.
Obstacles to opening an HSA
There are two major reasons why more people don't use health savings accounts. First, if your health insurance coverage is more comprehensive than what the HDHP requirements allow, then you can't open an HSA. Although employers are increasingly looking at HSA-eligible health insurance coverage, there are still many workers who can't use HSAs because their deductibles are lower than what qualifies for HDHP status.
The other primary issue with HSAs is that it isn't as easy to find a financial institution to let you open an HSA as it is with Roth IRAs and other more popular retirement accounts. Many well-known institutions limit HSA participation to employees at companies for which the institutions provide benefit-management services, such as 401(k) plan administration. Others don't offer HSAs at all. Theoretically, investors can take HSA money and invest it in a similar range of investment options as someone who opens a Roth IRA. But from a practical standpoint, it isn't as easy to get an HSA set up in the exact way you would want.
Nevertheless, health savings accounts have features that even Roth IRAs can't match, and that could lead to their becoming increasingly popular in the years to come. Once demand becomes stronger for HSAs, it should get easier for you to find investment solutions involving health savings accounts that will let you take maximum advantage of this lucrative tax break.
The article Why an HSA Is Even Better Than a Roth IRA originally appeared on Fool.com.
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