As you sign up for your 2013 employee benefits, be sure to take advantage of the Health Savings Account or Medical Flexible Spending Account. Both plans allow you to pay out-of-pocket medical expenses with pre-tax dollars.
Depending on the group health insurance plan in which you participate, you are eligible to utilize either a Health Savings Account (HSA) or a Medical Flexible Spending Account (FSA). By participating in either of these plans, you can pay for qualifying out-of-pocket medical expenses with pre-tax dollars. While there are many similarities between the two plans, there are also significant differences that you need to be aware of.
Flexible Spending Account
If you are participating in a traditional group health insurance plan, which is typically provided through a Preferred Provide Organization (PPO) or a Health Maintenance Organization (HMO), your medical savings account is the Flexible Spending Account (FSA). As a participant, you contribute pre-tax dollars from each paycheck to the FSA. The maximum that you can contribute in 2013 is $2,500. For 2014 and beyond, the maximum contribution will be increased for inflation. (Note: The 2013 limit is less than the 2012 maximum of $3,600.)
As medical costs are incurred that are not covered by the insurance plan, you request reimbursement from the FSA. Such costs include the deductible amount for your health insurance, required policy co-payments, prescription and doctor-ordered over-the-counter drugs, eyeglasses, contact solution, and other healthcare supplies. Since the company can be more restrictive regarding the reimbursement criteria, you should review the plan document.
All funds contributed to the FSA need to be used during the year. Some plans include a grace period of 2 ½ months, which extends a December 31 spending deadline to March 15. If you contribute more than you spend, the plan administrator keeps the difference. This “use it or lose it” rule requires you to make a good estimate of your upcoming medical expenses when determining your contribution amount.
Health Savings Account
When your medical coverage is provided through a high deductible health plan (HDHP), you are entitled to make pre-tax contributions to a Health Savings Account (HSA). One significant benefit of the HSA over the FSA is the ability to maintain any funds contributed, but not used. In other words, the “use it or lose it” rule does not apply. The HSA funds are never forfeited, even if the employee leaves the company. The account is completely portable and can continue to be utilized as long as the insured participant is eligible.
Any distributions from the HSA for qualifying medical expenses are not taxable. Qualifying expenses are similar to those noted above for the FSA. While HSA funds cannot be used to pay the insurance premium for the HDHP, the funds can be used to pay COBRA coverage, qualified long-term care insurance premiums, and the cost of any health plan while receiving unemployment compensation. An added benefit of the HSA over the FSA is the ability to use the funds after you retire. Once an individual is over age 65 and elects to utilize the government Medicare coverage, the HSA funds can be used to pay for Medicare Part A or Part B coverage.
The funds in the HSA can be invested. Any income earned in the HSA is not taxable as long as any withdrawal from the HSA is an eligible expense. If you use the funds in the HSA to pay expenses that do not meet the eligibility requirements, the withdrawal amount is subject to income tax plus a 20% penalty. However, once the participant (account beneficiary) is over age 65, there is no penalty for using the funds for other non-qualifying expenses. However, similar to IRA distributions, the funds will be taxable.
Like the FSA, you can make contributions to an HSA through payroll deductions. However, HSA contributions can also be made with a periodic deposit or transfer from a bank account. Contributions can be made to the HSA beginning in the first month of eligibility through April 15 of the following year. Any personal contributions not made via your payroll are deductible from adjusted gross income; therefore, allowing all contributions to be pre-tax. Employers are also eligible to make pre-tax contributions to employee HSA accounts.
The contribution limit for 2013 is $3,250 for an individual or $6,450 for a family covered by the HDHP. For insured participants that are over age 55, an additional contribution of $1,000 can be made. Once an individual begins to participate in the government’s Medicare health insurance system, HSA contributions can no longer be made for his/her benefit.
Any funds remaining in the HSA at the end of the plan year are carried over to the next year and continue to be invested. In the event of death or divorce, the HSA account can be provided for the spouse's use without being subject to taxation. However, if a non-spouse inherits the HSA, the account ceases to be an HSA and the funds become taxable.
What’s the Benefit of an FSA or HSA?
By using pre-tax dollars to pay for your medical expenses, you are significantly increasing your personal purchasing power. Without a Medical FSA or HSA, you would need to earn $1,250 in order to pay medical expenses of $1,000. This assumes a low federal tax rate of 15% and a state and local rate of 5%. If you are subject to the highest federal tax rate of 35% with an additional 5% state/local tax, you would have to earn $1,667 to pay a $1,000 medical bill. Obviously, the higher your marginal tax rate, the greater the benefit. But even at the lower tax bracket, by utilizing an FSA or HSA, you save $250 dollars for every $1,000 you must pay for medical costs!
Summary
If you are eligible to participate in either an FSA or HSA, it is important that you do so. While the HSA is more flexible and has significant advantages over the FSA, both plans allow you to pay medical expenses with pre-tax dollars. This is too good of a benefit to pass up.