Intervention in a complex system always creates unanticipated – and often undesirable – outcomes.Economists and sociologists call this the Law of Unintended Consequences. And while the unintended consequences that get our attention tend to be negative, there may be “happy accidents” as well. As the details from each phase of the Patient Protection and Affordable Care Act (PPACA) become apparent, some financial commentators think they may have uncovered some unexpectedly favorable possibilities.
Introduced in 2003, Health Savings Accounts currently permit individuals with high-deductible health insurance plans to contribute up to $3,300 annually on a pre-tax basis for anticipated out-of-pocket medical expenses (the threshold is $6,550 for a family, with an additional $1,000 if over age 55). Any earnings on the deposits are tax-free, as are withdrawals – as long as the money is used for qualified medical expenses. In addition, unused balances are allowed to accumulate. After age 65, HSA funds can also be used to pay insurance premiums, including Medicare and long-term care insurance.
Similar to an IRA or other qualified retirement plan, withdrawals for other purposes are taxable as regular income. However, if funds are withdrawn before age 65 for non-medical reasons, a 20% penalty is applied.
From this brief explanation, it’s possible to see some attractive opportunities with HSAs. As Retirement Management Analyst Dana Anspach says:
“Where else do you get to contribute tax-deductible dollars and withdraw them tax-free? Health insurance premiums and medical expenses of some kind are a certainty. Why not pay for them with tax-free dollars? I can think of almost no downside to funding an HSA instead of an IRA. If you don’t need your HSA funds for medical expenses or insurance premiums then after age 65, you can use the money just like funds in your IRA or 401k.”
It is important to remember that you can’t establish an HSA unless you also are enrolled in a qualifying high-deductible health insurance plan.
Some companies provide high-deductible health plans for their employees, often including some allocation to partially fund the accompanying HSA. But when the mandate that Americans must be enrolled in a health insurance plan became effective for individuals in January 2014, it indirectly expanded the number who might want to establish an HSA.
PPACA established minimum benefit provisions for individual health insurance plans. In many cases the new standards were more expansive than previous plans, and insurers were required to accept all applicants. Not surprisingly, offering more benefits on a guaranteed-issue basis has resulted in higher premiums, in some cases significantly higher. As an unintended consequence, these higher prices have compelled more individuals to consider high-deductible health plans – which may also make them eligible for HSAs. (Many of the policies in the PPACA’s “bronze” classification qualify for pairing with an HSA.)
The investment options in an HSA vary by the provider. Some offer only guaranteed or low-risk choices, assuming most of the money will be distributed within a year of deposit. Other institutions include long-term choices, similar to those for IRAs and other qualified plans.
IRA or HSA?
For self-employed households and individuals in good health, HSAs may present an intriguing workaround to the higher costs of health insurance while still maintaining an accumulation program. If last year’s budget included health insurance premiums and contributions to an IRA, it may be possible, for about the same amount of money, to construct a new plan using a high-deductible health plan and an HSA.
This arrangement is not equivalent to the old one; if the health plan premiums are about the same, the benefits from the new insurance coverage are probably less, and out-of-pocket medical expenses potentially higher. But using the HSA allows these additional out-of-pocket expenses to be paid on a tax-free basis, with unused portions accumulating for retirement. If the individual remains healthy, a larger portion of the HSA balance may eventually be allocated to long-term investments, like the IRA.
Even if an individual’s budget could afford higher health plan premiums and still maintain IRA contributions, HSAs might be the more attractive option. Consider the chart below, showing the tax treatment of the three tax-favored accounts available to individuals.
Like Ms. Anspach says, out-of-pocket medical expenses are an almost certainty. This means some money accumulated in an HSA can almost certainly also be spent on a tax-free basis – well before retirement. A significant medical event presents one of the greatest risks for financial disruption, and accumulating a substantial reserve in an HSA is a financially efficient way to protect against it, both now and later. Improving longevity makes medical expenses a greater financial concern in old age, so the ability to take tax-free distributions in retirement for medical expenses, insurance and long-term care could be extremely valuable.
The constantly changing landscape of government regulation and tax policy makes it impractical to think that an HSA could be one’s primary destination for retirement saving. But if your individual or employee circumstances include enrollment in a high-deductible health plan, the option to pair it with an HSA should be carefully evaluated, as there are many scenarios under which HSA funds may be deposited, grow, and be withdrawn completely free of tax consequences.