If you’re just stopping by for the first time, this is a class in a series of classes over the next few months which will culminate in the development of a complete financial plan.  Stop by HERE for a complete list of classes currently available and HERE for more information about the website.

Class Objectives: To learn about the benefits of contributing to a Flexible Spending Account or Health Savings Account to pay medical expenses with tax-free funds.
Prerequisites: IN203: Medical Insurance Basics
Handout: none
Assignment: Download the estimated medical expense spreadsheet for Excel | Google Docs (previews in lecture material below and also used in class IN203: Medical Insurance Basics

CLASS LECTURE

I’m sure we can all agree that healthcare costs in the United States are out of control.  While I have mixed feelings about the Affordable Care Act (aka Obamacare), I do understand the purpose.  By requiring insurance companies to allow preexisting conditions, it allows for the previously uninsured to obtain medical insurance.  After all, medical bankruptcies account for well over half of all bankruptcies, so it’s definitely a serious issue and one that can completely destroy one’s finances (although I realize that not all of these people were uninsured).  Mandating that all Americans must have medical insurance also means that more “healthy” people are pulled into paying for medical insurance, which is meant to subsidize costs across the board for everyone.

But, what about the millions who have health insurance, but still can’t afford to pay their medical bills?  While these two things probably won’t be the breaking point to being able to pay your medical bills, Flexible Spending Accounts (FSA’s) and Health Savings Accounts (HSA’s) can definitely help to make medical expenses less expensive.

Retirement presents another set of problems, namely most people having less than sufficient medical insurance coverage (now that they cease to have employer-provided plans) coupled with more medical expenses than ever.  An HSA can provide a good solution for setting aside money to pay for the increasing medical costs that we are likely to face in retirement.

Throughout our years of employment, we’ve had both an FSA and HSA.  Both of these accounts provide the ability to contribute tax-free money to use for medical costs.  There are quite a few differences between the two accounts, though, so let’s start with the details.

FLEXIBLE SPENDING ACCOUNTS (FSA)

Flexible spending accounts are offered only through employers (not available to the self-employed).  They can technically be used in conjunction with any type of healthcare plan, but are typically used with PPO or HMO plans that do not qualify as high-deductible health plans (which allow the use of an HSA account instead).

Contributions to the following calendar year FSA are determined at open enrollment time.  This requires you to estimate your future year medical expenditures well in advance and elect a monthly deferral amount.  If you don’t use the funds by a certain date, you lose the funds.  Employers set the exact deadline, but the IRS does not allow deadlines past March 15 of the following year for which funds are contributed. Alternatively, companies might offer the ability to roll over up to $500 in FSA funds instead.

Because using an FSA requires you to accurately measure your expected out of pocket health care expenses for the year, it’s important to be organized and detail-oriented about determining this number.  I’ve shared this spreadsheet in our previous class IN203: Medical Insurance Basics and am previewing it below as well.  I highly recommend going through your medical expenses for 2016 to help accurately fill out the costs for services that you expect to have in the coming year.  Be sure to only include the costs that you would personally pay, so if you have an HMO plan, you would want to adjust the cost to the copays for each service.

Despite the restrictions, at least putting a small amount of money in your FSA, if your employer offers one, is better than paying ALL of your medical expenses with after-tax dollars.  Not only do you avoid federal (and likely state) taxes on FSA contributions, they are also not subject to FICA taxes.  I’ve talked about how I personally pay even more FICA taxes than any other type of tax in this post (this is no small thing to avoid this extra 7.65% tax!).  Just make sure that you are certain that you will use these funds by the cut off date so that you don’t risk losing them.

Currently, FSA contributions are limited to $2,550 in 2016 and $2,600 in 2017.  Employers can make additional contributions to an FSA account as well.  For a typical American family (assume a 15% federal tax bracket, 5% state tax bracket and 7.65% FICA taxes), this savings could be over $700.  The contribution limit seems low, especially when compared to an HSA below, but that’s still a sizable saving that you should consider!

Examples of qualified medical expenses that are eligible for reimbursement from an FSA include:

• Medical exam copays/deductible
• Vision exams
• Prescription glasses or contact lenses
• Dental exams, fillings or other dental work
• Therapy and other psychological treatment
• Flu shots
• Prescriptions
• Over-the-counter medication with a doctor’s prescription
• First-aid supplies (thermometer, band-aids, splints, braces, etc.)
• Sunscreen
• Transportation costs for medical reasons (mileage rate provided by the IRS annually with additional limits)
• Smoking cessation programs

If you have additional questions about what you can use your FSA funds for, you can consult IRS Publication 969 or also see fsastore.com, which caters to those wishing to purchase last-minute supplies to use up their FSA funds by year end.

To actually use the FSA funds, companies often offer an FSA debit card, or there is generally a simple process where you submit your medical receipts along with a claim form and they reimburse you for the expenses.

Related Post: Tracking Your Medical Expenses & Claims

HEALTH SAVINGS ACCOUNTS (HSA)

Health savings accounts are a fairly new medical reimbursement plan (since 2003) that provides benefits to those with high deductible health plans (referred to commonly as HDHP).  Having a high-deductible plan is a requirement to be able to contribute to an HSA account, although you can still use your HSA account in future years even if you move to a different type of health coverage (or none).

High deductible health plans are defined as plans that:

• Have a minimum deductible of $1,300/$2,600 (self/family) for 2016 & 2017.
• Have maximum out-of-pocket expense limit of $6,550/$13,100 (self/family) for 2016 & 2017.

HSA accounts have even more tax benefits than an FSA account.  Not only are the contributions not subject to federal, most state and FICA taxes (yay!), you can invest the funds and the income is not taxed ever as long as the funds are used for qualified medical expenses.  This is generally referred to as a triple tax benefit, but with the additional consideration that it is free from FICA taxes as well, I would consider it a quadruple tax benefit.

1. Tax-free contributions for federal income tax (or tax-deductible if contributions are being claimed on tax return instead of withheld from a paycheck)
2. Tax-free contributions for FICA tax purposes
3. Tax-free investment income (interest, dividends, and capital gains)
4. Tax-free distributions if used for qualified medical expenses

HSA contributions must be made by the due date of the return for that calendar year (generally April 15^th).  The current contribution limits are shown in the table below.  Employer contributions are included in the totals, so if your employer makes a contribution it does reduce the amount you can personally contribute (not a bad thing for you, though!).  Generally, HSA contribution amounts can be changed mid-year if your medical needs changed.

Qualified expenses for an HSA mostly include the same costs overall.  However, it’s also possible to pay for certain health insurance premiums with an HSA account.  Examples of qualified medical expenses that are eligible for reimbursement from an HSA include:

• Medical exam copays/deductible
• Vision exams
• Prescription glasses or contact lenses
• Dental exams, fillings or other dental work
• Therapy and other psychological treatment
• Flu shots
• Prescriptions
• First-aid supplies (thermometer, band-aids, splints, braces, etc.)
• Over-the-counter medication with a doctor’s prescription
• Health premiums but only for COBRA continuation, while receiving unemployment benefits, Medicare and long-term care insurance

If you have additional questions about what you can use your HSA funds for, you can consult IRS Publication 969.

If you use HSA funds to pay for anything other than qualified medical expenses, you will face a 20% tax penalty as well as ordinary income tax on the withdrawals.

Since an HSA account is similar to a bank account, most offer a debit card for purchases, or you can follow a process where you submit your medical receipts along with a claim form and they reimburse you for the expenses.  Our HSA also offers the ability to submit a provider name and claim details and they will directly pay the bill for the service.

In addition, you can invest HSA funds if your balance reaches a certain level specified by your HSA provider.  This allows you to really grow your account if you are saving for long-term medical expenses in retirement.

Unlike an FSA account, an HSA account is portable, even if your employer contributed some of the funds.  Self-employed people can open an HSA account (as long as their insurance coverage meets the HDHP requirements) at a company of their choosing and compare fees and benefits.

There is yet another thing that is amazing about a Health Savings Account.  If you don’t use the funds by age 65, you can withdraw the funds penalty-free, although ordinary income tax rates will apply.  It’s similar in that regard to a Traditional IRA, but better because you avoid paying FICA taxes on it as well.  In fact, I’d take it over a Traditional IRA contribution for sure if I had to choose between them.  An HSA is a great retirement tool, even if you don’t end up using the funds for medical expenses!

You should fund your HSA at a minimum to the amount you determine that you will likely need for medical expenses during the year (obtained from the spreadsheet previewed above in the explanation of FSA accounts).  However, due to the fact that HSA funds carry over indefinitely and can also be used as retirement savings, I recommend contributing as much as possible up to the limits.  A start would be to have your maximum out-of-pocket amount funded in your HSA.  Then even a major medical emergency would be completely covered with pre-tax funds.  And, how great would that be that you wouldn’t have to worry about money at all during that time?

FSA vs HSA

If there’s a choice between an FSA and HSA, the HSA will win due to its flexibility in being able to carry forward and invest the funds.  Note that you cannot contribute to both an HSA and FSA in the same year, with very few exceptions (there is a limited purpose FSA for only vision and dental costs).  Those who have a spouse covered by an FSA at a separate employer will not qualify for an HSA.

To quickly summarize the main differences between FSA and HSA accounts, see the following table:

EXAMPLE: THE SMITH FAMILY

The Smith family has a high deductible health plan that qualifies them to contribute to a Health Savings Account.  Looking closer at Jim’s employee benefits, he finds that he would receive a 50% match on HSA contributions up to $1,500.

To reiterate from a previous class, he has a family healthcare plan with an annual deductible of $2,750 and a maximum-out-of-pocket amount of $5,000.

Because he has family coverage, his maximum contribution would be $6,750 which would more than cover his plan’s maximum out-of-pocket amount of $5,000.

HOMEWORK ASSIGNMENT

Your homework assignment is to estimate your medical expenses for the current/following year and fund an FSA (if it’s not too late) or HSA to cover the costs with pre-tax funds.  As mentioned earlier, be sure to only include the costs that you would personally be responsible for in the spreadsheet calculation.

• IMPROVING – Obtain your total out-of-pocket medical expenses from your insurance company (this will be your amount toward your deductible if you have an HDHP plan).  Determine if you’ll have significant differences in this year to get your total FSA/HSA funds needed.
• INVESTED – Determine your expected medical costs for the current/next year using the spreadsheet and adjust your FSA/HSA contributions as currently possible.
• UNSTOPPABLE – Determine your expected medical costs for the current/next year using the spreadsheet as above and if you have an HSA account make a goal/plan to fund as much as possible up to the contribution limit.

Are you currently contributing to an FSA or HSA account?