It’s important to understand the type of health account you have or could have, so you can take full advantage of any tax benefits.
Three common types of tax-advantaged health accounts are health savings accounts (HSA), health flexible spending accounts (FSA) and health reimbursement arrangements (HRA).
What’s the difference between these accounts?
HSAs are accounts you set up yourself. You can set up an account at your bank or credit union, for example. With this account, you can keep it no matter where you go or where you work (or if you work at all). You, and possibly your employer, contribute to the account throughout the year.
The only stipulation is you must have a High Deductible Health Plan (HDHP) to have an HSA.
A HRA is set up, owned and funded by your employer only.
An Health FSA is much like an HRA. It is owned by your employer, but it can be funded by you and your employer.
Can I earn interest on money in the account?
You can earn interest on money in your HSA. You cannot earn interest in the other two types of accounts.
Can I take taxable withdrawals from my health account after retirement?
The HSA wins again on this one. You can accumulate large amounts of money in an HSA and take it out as taxable income after retirement. In that case, it works much like a traditional Individual Retirement Arrangement (IRA).
Taxable withdrawals for purposes other than healthcare expenses are not allowed for HRAs and Health FSAs.
HRA balances may roll over from one year to the next, however employers often limit the rollover. This would deny you access to the funds during retirement.
Yet, in some instances, employers do allow past employees to have access to their HRA accounts throughout their retirement years.
But, there’s a good chance they will not continue to contribute to the account once you’ve left the position.
Unfortunately, health FSAs typically expire upon the date of the separation from your employer.
If I don’t use all the money in my health account, do I lose it?
Many people are familiar with “use it or lose it” health accounts. If they didn’t use up all of their health account balance by the end of the year, the money was gone.
As a result, many will rush to buy glasses or spend the dollars on other healthcare expenses by December 31 in order to take full advantage of the benefit.
One of the main advantages of an HSA is you don’t forfeit your balance if you haven’t used it by the end of the year.
In fact, you can accumulate a serious amount of money in an HSA – which isn’t a bad idea. If you ever have a major medical emergency, the money will be there.
An HRA may allow you to carry your balance forward from year to year, but only if your employer allows it.
A health FSA, on the other hand, limits your ability to carry balances forward. In some cases, employers may opt to allow you to carry forward up to $500 or give you an additional 2.5 months to use your balance. Ask your employer for details.
How do health accounts save taxes?
When you make qualified contributions to an HSA, HRA or health FSA, you can take a deduction for the amount of your contribution or your contributions can reduce your taxable income on Form W-2. Either way, your income tax bill goes down.
If your employer makes qualified contributions for you, the amount of their contributions is not taxable.
With all three plans, when you spend the money on qualified health care expenses, you do not pay tax on account withdrawals.
Health account contributions do not reduce your income tax subject to Social Security and Medicare tax.
Why not take a tax deduction for medical expenses instead?
Instead of setting up a health account, you could pay for your medical expenses with after-tax dollars and take a deduction. However, there’s one major problem with that.
You can only deduct medical expenses to the extent they exceed 10 percent of your adjusted gross income (7.5 percent if you or your spouse is 65 or older).
There goes most or all your deduction. If you qualify for a health account or other plan, it’s usually well worth the trouble to set it up and use it for your medical expense needs.