Using your Health Savings Account for Long-Term Care

By Heaven Goodwin, CFP® | May 31, 2013 | Featured Articles, Plan for Retirement

Health savings accounts (HSAs) are one of the most tax-favored savings vehicles available to Americans. While they can serve many purposes, an under-utilized application of HSAs is using them as a funding source for long-term care costs. Before we dive into this option, let’s start with the basics.

What is an HSA?

First authorized by Congress back in 2003, HSAs are savings accounts that provide favorable tax treatment to their owners. In order to contribute to an HSA, you must be covered under a high-deductible health plan (HDHP) – subject to certain requirements.

High-deductible health plans are a type of health insurance that trade lower monthly premium amounts for a high deductible requirement that policy owners must meet before the insurance company will participate in cost sharing. After meeting the deductible, policy owners are responsible for covering a portion of expenses until they reach a maximum out-of-pocket limit established by the insurance company. This type of plan can work well for younger, generally healthy individuals not expecting any large medical events to occur in the near future.

HSAs were introduced to create an efficient way for individuals participating in these plans to save for and finance medical costs, while also receiving some tax advantages:

• Contributions to an HSA are tax-deductible
• Withdrawals can be taken tax-free for qualified medical expenses of the plan participant, their spouse, or their dependents
• Any earnings from interest or growth of the funds invested in an HSA also occurs tax-free (when withdrawn for qualified medical expenses)

What are HSA requirements?

For 2021, HDHP policies require the owner to pay a minimum deductible of $1,400 for a single person or $2,800 for a family policy. To be eligible for an HSA, the HDHP policy must also have a limit on the out-of-pocket expenses that policy owners are required to pay – this limit for 2021 is $7,000 for a single person or $14,000 for a family policy.

HSAs provide an incentive for HDHP policy participants to save for medical expenses by allowing the high deductibles to paid with pre-tax dollars. In fact, many companies pair HDHP insurance policies with annual contributions to the HSA equal to the amount of the minimum deductible. Individuals may also add pre-tax dollars to the account, lowering their taxable income for the year.

The maximum annual contribution allowed to an HSA (employer and employee combined) is $3,600 for an individual policy or $7,200 for a family policy for 2021. This amount is indexed for inflation. Individuals aged 55 and older can contribute an additional $1,000 per year as a “catch up” contribution.

What’s the benefit of using an HSA?

The biggest benefit of HSAs is that any money contributed that is unused is allowed to carryover at the end of a year and accumulate, unlike Flexible Spending Accounts (FSAs). The funds can be invested in a variety of securities, and growth over time can be used to fund future health care expenses tax-free.

Because of this tax-free growth, HSAs can be an advantageous method of saving money for future health care needs, particularly long-term care needs. When done correctly, this method of “self-funding” long term care expenses can be incredibly cost-effective compared to the high premiums of most long-term care insurance policies. To receive the most benefit, funds in HSAs should be left to grow compounded for as long as possible before they are withdrawn for medical care costs.

HSA Restrictions

Now, it’s important to note the limitations of HSAs to avoid triggering taxes and penalties on funds as they are withdrawn. The first, and biggest, limitation is that not everyone is eligible to participate in an HSA. As mentioned previously, individuals must be enrolled in HDHP insurance policy to be able to contribute to an HSA. While individuals can still contribute to an HSA after they turn 65 years old, this option goes away after enrolling in Medicare.

In order to receive tax-free status for withdrawals, money taken from an HSA can only be used for qualified medical expenses. Qualified medical expense requirements are the same as those applied to medical expenses itemized on Schedule A (although expenses paid for through an HSA cannot also be itemized). This means HSA funds can be used to pay for long-term care policy premiums, qualified long-term care services, COBRA coverage, health care coverage while unemployed, Medicare, or other health coverage once age 65 or older.  If the funds are used for nonqualified expenses, the full amount will be subject to income tax and, for those under 65, will also face a 20% penalty.

What happens if I save in an HSA and end up not needing the funds for medical purposes?

First of all, congratulate yourself on your good luck! Not only are you healthy, but you still have access to your savings.

After age 65, distributions from an HSA are no longer subject to the 20% penalty. While money taken out for non-qualified expenses will be subject to ordinary income tax, the result is a tax-deferred situation similar to saving money in a traditional retirement account since taxes were never paid on the HSA contributions.

Upon the death of an HSA owner, the surviving spouse can assume the HSA as his or her own policy. Any other beneficiary must pay ordinary income tax on the fair market value of the account. Again, this treatment is comparable to a traditional retirement account.

Is it better to save money for long-term care costs or to simply buy a long-term care policy?

While the specific answer will vary according to a person’s situation and needs, the short answer is that long-term care policies tend to provide more coverage but come with the potential for a big sunk cost –  money paid for the policy is not returned if long-term care is not needed. Investing money in a health savings account will likely not provide as much coverage but does preserve wealth for those who end up not needing long-term care. Another important consideration is that long-term care policy premiums can be, and have been in recent history, raised by insurance companies (with approval from state regulators) leading many policyholders to abandon their coverage without receiving any benefits.

If you’re wondering about how you would cover long-term care costs, speaking with a financial advisor can give you more insight into which option is best for you. Regardless of whether the funds are earmarked for long-term care coverage, those who have the ability to save in an HSA should strongly consider taking advantage of the benefits received from doing so.

*This article was originally written by a Monument team member for U.S. News & World Report and was most recently updated by Monument’s Financial Planning Team member, Heaven Goodwin, in June 2021.

Read the original article on U.S. News & World Report…