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How Does a Health Savings Account Work?

Jeff Brown

Two-thirds of the way through the Obamacare enrollment period that ends Jan. 31, many seeking coverage are shocked at the prices, especially the huge out-of-pocket expenses piled atop crushing premiums. As health coverage gets more expensive, even people with workplace plans can face a crushing load.

But there's an opportunity to shave those costs with another government-approved option that predates the Affordable Care Act, but doesn't get as much attention: the health savings account or HSA. You can get one on your own or may find one paired with a high-deductible health insurance plan from your employer.

"Since contributions are tax deductible, HSAs can provide an extremely tax-efficient way to cover the gap between your insurance deductible and when your benefits start kicking in," says Hampton Bourne, a financial advisor in Nashville, Tennessee.

"Whether it's for an unforeseen instance like an accident, or braces for the kids, you will eventually find a use for one, and you might as well get the tax deduction for that money," Bourne says. "Depending on your income and tax bracket, it could save you thousands in taxes."

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Around since 2004, HSAs work much like IRAs, allowing participants to avoid federal income tax on money put into the account for health care expenses. Investment gains and withdrawals for qualified expenses are also tax-free. A $10,000 health care expense could therefore cost you just $7,500, assuming a 25 percent tax bracket. An HSA won't eliminate big medical costs, but it could help a bit.

By reducing taxable income, an HSA can also help an individual or family qualify for federal subsidy with Obamacare premiums, or increase the subsidy.

There are lots of rules, of course, and it's important to be sure the health insurance you choose qualifies. Not all do, even many offered through Obamacare.

Maximum annual contribution for 2017 is $3,400 for an individual, $6,750 for a family, with an additional $1,000 allowed if the policyholder is 55 or older. The policy must have maximum out-of-pocket expenses of $6,550 for an individual, $13,100 for a family, after which the policy covers costs.

The HSA can be used with many Obamacare plans that have an annual deductible of at least $1,300 for an individual or $2,600 for a family. Check with your health care plan to be sure it is eligible for an HSA. Generally, the HSA is used to pay out-of pocket expenses, not premiums.

If you lose or give up your high-deductible plan, you can no longer contribute to the HSA but can keep the assets and continue using them tax-free.

Money in an HSA can be "rolled over," or used in the future if not spent in the current year. This can make an HSA a better option than an employer-sponsored flexible spending account, which has a use-it-or-lose-it rule.

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Money withdrawn from an HSA for non-qualified expenses is taxed as income and charged a 20 percent penalty, though policyholders 65 and older can withdraw for any purpose and pay tax but no penalty, making the HSA useful for retirement expenses after one becomes eligible for Medicare at 65.

The ideal candidate for an HSA is an individual or family with low medical expenses or an HSA available through an employer, says Justin Chidester, owner of Wealth Mode Financial Planning in Logan, Utah. People with low medical expenses benefit from having health insurance policies with high deductibles they are unlikely to pay. Those with employer-backed HSAs may get tax-free contributions from the boss.

He notes that a taxpayer's contribution to an HSA is taken as an "above-the-line" deduction that reduces adjusted gross income, making it valuable even if the taxpayer does not itemize. A taxpayer with an HSA should file IRS Form 8889 with the federal return.

As with most matters involving tax breaks, an HSA can be most valuable to a person or family in a high tax bracket, says Jason Lina, an advisor with Resource Planning Group in Atlanta who describes himself as a "huge advocate" of HSA plans.

He believes HSAs benefit people with high medical costs as well as low, and that the only people who cannot benefit are those who simply cannot afford to pay the high deductibles of HSA-qualified plans.

Greg Szymanski, director of human resources at Geonerco, a real estate developer in Seattle, says HSAs work best for people in good health with the discipline to set money aside regularly. "With no use-it-or-lose-it limitations like with a flexible spending account, account balances at year end simply roll over to the next year," he says. "Those with the discipline to save can build quite a nest egg for medical expenses."

As mentioned, an HSA can be set up at the workplace if the employer offers that option, or directly with a financial institution such as a bank. Search for "open an HSA account" to find providers.

"Best way to set up is with a bank or credit union you already have a banking relationship with," Szymanski says. "If the bank or (credit union) offer these accounts, this is the best way to avoid HSA financial institution imposed fees. There are several online banks that administer HSAs such as HSA Bank, HealthEquity, Optum Bank, but fees tend to be higher than an HSA at a financial institution you have an existing relationship with."

Your mutual fund company or brokerage may be able to connect you with a provider that allows HSA assets to be invested in mutual funds, though most experts warn against taking too much risk with money that may be needed for an emergency on short notice. "Fees are the No. 1 thing to look out for," Szymanski says.

While any tax-advantaged plan could lose its appeal if Washington changes the rules, Lina thinks that's not much of a risk with HSAs.

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"Employers like HSAs, Republicans like HSAs, and Democrats like HSAs, so I don't see much threat of them going anywhere or being paired back," he says. "The trend has to expand the benefits of HSAs so that more people use them."

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