Daily Deduction: Health Spending Accounts


Anyone who has tried to wade through the health care tax laws knows the deeper you get, the further you can be from understanding them.

No matter what else you may think about substantive health care reform, the need for simplification of the related tax provisions is something about which we can all agree.  Sadly, that day hasn’t arrived, yet.  In the meantime, here is some helpful information about two of most common health care tax breaks—the flexible spending account (FSA) and the medical savings account (MSA), or health savings account (HSA).

Flexible Spending Account
Most of us are familiar with the flexible spending account.  It is an account provided by your employer for reimbursement of medical expenses.  Each year, you elect to have a portion of your paycheck deposited into the account pre-tax.  Then, when you have medical expenses, you submit receipts to your employer and receive reimbursement from your account.  The good news is that the money you contribute to your account is not taxed.  But the bad news is that you have to use it or lose it.  If you contribute more money to the account than you spend on medical care, your employer can’t refund your excess contribution, and it doesn’t carry over to the next year either.  It just vanishes, into the hands of your employer.

Because most of us aren’t related to Nostradamus, the “use it or lose it” system makes FSAs less than ideal for tax planning.  If you contribute too much, you lose your excess contribution.  But if you contribute too little, you forego valuable tax savings.

So what should a savvy tax planner do?

Start by keeping track of your yearly expenses.  Since some of them are recurring, like your annual checkup, your Acuvue lenses (Stock Quote: JNJ), or a year’s supply of Advil (Stock Quote: WYE), you’ll have a good starting point.  Add any other expenses you know you’ll incur.  Is this the year that you’re having knee surgery?  If so, throw in a little bit of extra dough. 

Finally, it’s better to contribute too little than too much.  There are two reasons why you should err on the side of shortchanging yourself.  First, if you contribute too much, you’ll lose your excess contributions.  Second, if your medical expenses are so hefty that your FSA won’t cover them, you may be able to deduct them on your Form 1040.  This isn’t a great option, though, because the medical expense deduction is limited, and it’s only available if you itemize.  In the end, your best bet is to make a close estimate, so be sure to keep good records from one year to the next.

Health Savings Account
If the “use it or lose it” aspect of the FSA doesn’t appeal to you, you might consider opening a health savings account or a medical savings account instead. These accounts are similar to individual retirement accounts, but they are used to pay for the cost of health care rather than the cost of retirement.  MSAs are limited to the self-employed and people who work for small employers.  Because the two accounts are nearly identical and because HSAs are more broadly available, we’ll focus on those instead. 

Contributions to an HSA are not taxed, and unlike contributions to an FSA, they remain in your account from year to year.  Like an IRA, the money in an HSA can be invested, and the investment return is not taxed.  As a result, it’s possible to contribute money to an HSA and let your money grow tax free until you need it.  This makes HSAs a good choice for people who anticipate few medical expenses in the near future.  Finally, distributions from your account are also tax free, as long as you use them for medical expenses.

Sound too good to be true?  Like every great tax benefit, HSAs come with a catch.  They are only available to people who are covered by high-deductible medical insurance.  This is less than ideal because a high-deductible plan requires you to cover more out-of-pocket expenses than a conventional plan would.  In other words, you have to take a real financial risk in order to get the tax reward.  If you are single, a high-deductible plan is one that has an annual deductible of at least $1,100.  For a family, the annual deductible must be at least $2,200.  These plans can require you to cover out-of-pocket expenses of up to $5,600 for a single person and $11,200 for a family.  Your employer will know whether your plan qualifies and whether you are eligible to open an HSA. 

Other restrictions apply.  In addition to the high deductible plan requirement, contributions to an HSA are limited.  In 2008, a single person could contribute up to $2,900, and a family could contribute up to $5,800.  These limitations are designed to correspond with the deductible amount of health insurance plans.  If you need it, your deductible amount will be available to you through your HSA.  If not, it will continue to grow until next year.  This brings us to one final and important limitation, which applies to distributions.  You can withdraw money from an HSA to cover your medical expenses, but if you withdraw it for any other reason, you will have to pay taxes and penalties on your withdrawal.

So who would benefit from having an HSA?  If you are in good health, an HSA might be a good option for you.  High deductible health insurance plans usually have lower premium payments.  This means that you’ll save money on your monthly health insurance bill.  Instead of giving that savings to an insurance company, you can put it into your HSA, where it will grow tax free until you really need it.  Even better, some high deductible health insurance plans fully cover preventive care costs, like annual visits to the doctor.  If you have one of these plans, not only will you save on your monthly premium, but you won’t have to pay very many out-of-pocket expenses either, which means that your HSA balance will be preserved.  For healthy people who don’t have many medical care costs, this is a good deal. 

The high cost of health care takes a bite out of everyone’s budget, so Congress has given smart tax planners some tools to help.  They’re not easy, or perfect, but with a little bit of planning, they can help you save money.  If you make careful estimates, the FSA can cut the cost of your medical expenses from year to year.  And if you don’t have many yearly expenses, the HSA will allow you to invest your money in an account where it can grow to cover future expenses.  With these helpful options, visiting the doctor or the dentist doesn’t have to be (too) scary anymore.

Looking for more tax facts?  Be sure to check out the complete archive of Daily Deductions.

Related Stories:

Healthcare Pre-Tax Accounts: A Comparison

Daily Deduction: Medical Expenses

Daily Deduction: Roth v. Traditional IRAs

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