As if the American health care system weren't complicated enough for consumers, more and more people are being offered the opportunity to participate in tax-advantaged spending and savings accounts that can be hard to understand. As these accounts make medical expenses easier for many to bear, it's worthwhile to investigate what they might do for you.
Flexible spending accounts (FSAs) are employer-sponsored arrangements people can use to pay for various expenses. There are FSAs for medical and dental care, for dependent care, and for transportation to and from work. Money you contribute to an FSA is pre-tax, deducted from your pay and deposited into this account. Funds in a medical/dental FSA can only be used on bills for qualified, unreimbursed procedures, services, devices and medications (a list is available from IRS Publication 502). These expenses include deductibles and copayments related to your insurance plan.
If, at the end of the year, you have not spent all the money in this account, you will forfeit the amount not spent. Accordingly, you should carefully estimate what you will definitely spend on health care costs before deciding on the amount you will save. With some employer plans, there is a 2 1/2-month grace period after the end of the year to spend leftover amounts. There is no tax advantage in amounts spent exceeding the upper limit you have established.
For 2013, there is a $2,500 cap on FSAs. Prior to 2013, there was no statutory cap, although employers did establish them. You can compute your tax saving using your marginal tax rate. For example, if you spend $2,500, and you are in the 28 percent tax bracket, participating in an FSA would save $700.
A health savings account (HSA) works a little differently. It is established for individuals who are enrolled in a high-deductible health plan, who have no other medical coverage (including Medicare), and who cannot be claimed on someone else's tax return. Employees can establish an account even if their employer has not done so. HSAs can be established at any time during the applicable year.
HSAs have the following tax advantages: contributions made by your employer can be excluded from gross income; your contributions are tax-deductible even if you don't itemize; income earned on all contributions is tax-free. As long as you use the funds in your account for qualified medical expenses, they are not taxable.
The minimum required deductible for 2013 is $1,250 for self-only and $2,500 for family coverage. Individuals can contribute up to $3,250 annually to the HSA, and families can contribute up to $6,450. With HSAs, you are not penalized for not spending all the funds in your account in one calendar year. Funds not spent simply roll over from one year to the next.
There is an upper limit to what you may have to spend out-of-pocket in one calendar year. For 2013, the maximum is $6,250 for self-only and $12,500 for family coverage. These expenses include deductibles, copayments and other expenses, but not premiums. If you use HSA funds for nonmedical expenses before age 65, there is a penalty of 20 percent. Income taxes would also be due.
HSAs can be established up to age 65. No additional contributions can be made after an individual has signed up for Medicare. However, funds that are already in the HSA account can be used after age 65 for qualified medical expenses. After age 65, or if you become disabled, there is no penalty for using funds for nonmedical expenses; however, those funds will be taxed.
HSAs have some restrictions that FSAs don't have, such as cosmetic surgery and some elective procedures, such as eye surgery. See IRS Publication 969 for an explanation of requirements and restrictions associated with HSAs and FSAs.
You can establish an HSA with insurance companies, banks or other financial institutions. As you should when establishing any investment account, note the interest earned on your savings, fees and management costs that any HSA trustee offers, and shop around if possible.
Under certain circumstances you may be able to use both an FSA and an HSA. If your employer offers a limited purpose plan FSA (e.g., for dental, vision or preventive care), you may also be eligible for an HSA. You can review this with a company benefits representative.
The bottom line is that if you are spending a substantial amount of money for out-of-pocket health care costs, you should consider whether one of these programs can benefit you.
(Elliot Raphaelson welcomes your questions and comments at firstname.lastname@example.org.)