Making the most of that shiny new HSA

By Matt Stroud

NEW YORK (Reuters) - Health savings accounts have been around for almost a decade, but lately people have been snapping them up like they are milk and rock salt, and a big snow storm is brewing.

Enrollment in these specialized tax-deductible, tax-free accounts has exploded: In March 2005 there were slightly more than 1 million accounts; a year ago there were 11.4 million, according to America's Health Insurance Plans, a trade group. Since then, the growth has been exponential, with Fidelity Investments saying its HSA business grew 61 percent in a year.

The idea behind these accounts is this: Consumers set aside pre-tax dollars in a special account that they can use for the out-of-pocket medical expenses that arise when they are in high-deductible plans.

Some of that new popularity stems from the growth of lower cost high deductible health insurance plans that are showing up in employer's benefit packages.

But the big tax advantages that these accounts confer on their owners is also significant.

"I don't know of anything else that has a triple tax advantage like an HSA," says Paul Ashley, a financial adviser with First Person Benefit Advisors in Indianapolis. "You pay into the account pre-tax; then it sits in the account, tax free, whether you acquire gains through interest or investments. And then when you spend money for a qualified purpose, you're not taxed there either. That's a powerful incentive."

Furthermore, account holders keep their accounts even when they change jobs, points out Jennifer L. Zegel, an associate with the Philadelphia-based law firm Reger Rizzo & Darnall. "I think HSAs have grown rapidly in recent years because they are portable."

Whatever the reasons, there's a decent chance that an HSA may be in your future. You may already have one.

USE IT OR KEEP IT

At first blush, HSAs sound like Flexible Spending Accounts - the tax-sheltered accounts that allow employees to set aside some of their pay to fund medical or dependent care expenses. But there's one major difference: While FSAs expire at the end of each year, HSA funds roll over year to year. HSAs also are sometimes confused with employer-funded health reimbursement accounts (HRAs). These accounts are set up by employers to reimburse employee medical expenses. HRAs offer similar tax benefits to HSAs and funds can be kept year to year, but HRAs are not transferable when an employee leaves his/her employer.

"The ‘use it or lose it' rule with FSAs scares the bejesus out of people," says John Hauserman, CFP and president of Retirement Quest Wealth Management in Baltimore. "But HSAs are different. I think of these plans as a health retirement account, something you can hold onto for a long time and use as you need it." Some account holders take advantage of this, saving and investing their HSAs from one year to the next so they can use them in retirement, when medical expenses may be high.

But before racing to sign up, consumers should consider some of the downsides and complexities of HSAs.

First, not all employers offer them. The 2011 Kaiser Employer Health Benefits annual survey found that only 23 percent of firms offering health benefits offer a high deductible health plan or an HSA-qualified plan.

And users should be able to shell out some money for their own health care. The high-deductible healthcare plans that allow individuals to use an HSA are required to have deductibles of at least $1,200 for individuals and $2,400 for families. Maximum deductibles are $6,050 for individuals and $12,100 for families.

Aside from preventative services such as an annual checkup with a doctor, there is no reimbursement for medical services until the deductible is reached. And after reaching the deductible, "people typically have to pay additional copayments and coinsurance on the care they receive, making out-of-pocket spending potentially quite a bit higher than the deductible," says Adam C. Powell, a healthcare economist and president of health insurance consulting firm Payer+Provider.

A PLAN FOR THE YOUNG

Ideal HSA candidates are young and likely not to see their doctor regularly, says D. Wes Rommerskirchen, a business development supervisor with Benefit Plans Plus in St. Louis. "If they're young and healthy - or, if they have a family, their family is healthy - they can use it to really build their funds," Rommerskirchen says. "And, when those health expenses hit, they'll have the funds available."

That's another reason why young and healthy people are best suited for HSAs; the accounts have an annual contribution limit of $3,100 for individuals and $6,250 for families.(Someone over the age of 55 can contribute an additional $1,000 each year under catch up provisions.) So it's possible that, in the event of a major medial incident during the first or second year of an HSA plan, individuals might not have enough cash set aside to cover the entire cost.

"It is important to try to keep at least the deductible saved in an HSA so that those expenditures can be made with pre-tax money, says Powell.

But there are limits on what those expenditures can entail. Health club dues, hair transplants and cosmetic surgery - as well as the other expenditures deemed "not includible" by the Internal Revenue Service (see IRS's Publication 502 for a list here) - are off limits. So are over-the-counter drugs such as Advil or Tylenol, unless they're prescribed by a doctor.

And individuals who pull money out of their HSAs for non-medical purposes will pay dearly for that: the withdrawal will be taxed as ordinary income and subject to an additional 20 percent penalty.

BACK DOOR RETIREMENT SAVINGS

Though non-medical withdrawals are always taxed as ordinary income, that 20 percent penalty is dropped at age 65, and that allows for some creative strategies.

Retirees, who presumably will face higher healthcare costs as they age, can use HSA balances built up over the years to supplant their retirement income. Even if they end up drawing down the money for non medical purposes in retirement, the end result is no worse than a traditional tax-deferred account.

Some advisers, like Zegel, suggest stashing the maximum contribution in an HSA, not using it until you retire, and then pulling money out to repay yourself for medical expenses you had when you were building the HSA. Of course that requires keeping all of your medical receipts for years and years.

HSAs can be a great option for many. But it's not right for everyone.

"If someone has chronic medical condition, it would not be a viable option," she says. "They would be paying too much out of pocket. But it's great for people who want to save for future medical expenses."