Deep Dive: Here’s one health-insurance choice that can save you money now and make you even more later

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Put in some extra time when you next select your health insurance plan, and you may find you can pay much lower premiums while also reducing your health-care costs for the rest of your life.

Whether you have health insurance through your employer or purchase coverage through an exchange set up through the Affordable Care Act (also known as Obamacare), the combination of a lower-cost, high-deductible health insurance and a health savings account may provide great advantages. You save on taxes immediately, the money can be invested for decades, and — unlike with an IRA or 401(k) account — you may never have to pay taxes on any of it.

Health savings accounts are different from flexible spending accounts

People often refuse to consider opening a health savings account because they believe it is a flexible spending account. The two are very different.

A flexible spending account, or FSA, is offered through your employer’s health insurance and allows you to set aside up to $2,700 in pretax money in 2019 (the Internal Revenue Service can raise the limit each year). That money must to be used for eligible out-of-pocket health-care expenses for you and your family that tax year or it is lost, except for $500 that the IRS lets you carry over to the next year. So the FSA can be useful if you have a good idea how high your out-of-pocket expenses will be, and if you don’t contribute too much.

Read: How to make the most of your HSA — for now, and the future

A health savings account (HSA) works differently. First, you’re only eligible if you have a high-deductible insurance plan. Second, you can shelter much more money from the tax man. Up to $3,500 (for an individual) or $7,000 (for a family) in pretax money is withheld by your employer (or set aside by you, especially if you buy your own health insurance) and placed in an HSA each year. (Again, these amount can change every year.)

Like the FSA, you can use money in the HSA to pay for out-of-pocket health-care expenses tax-free. But the HSA doesn’t have a “use it or lose it” feature.

The beauty of this is that an HSA can work as another way to save money for retirement, especially health-care expenses in retirement. And because you can invest and let the money build up over the years, you can capitalize on the magic of compounding. That $3,500 or $7,000 you set aside this year could double in nine years if you earn a 8.9% average return — which has been the average compounded annual growth rate for the S&P 500 index SPX, -0.04%  over the past 15 years, according to FactSet.

Of course, this assumes you have the ability to pay for today’s out-of-pocket expenses with other funds.

More advantages

An opportunity to increase tax-deferred savings may be especially important if you are self-employed or if no employer-sponsored retirement account is available to you. Federal law allows a person with a 401(k) or similar employer-sponsored retirement account to put away up to $19,000 in pretax dollars (plus another $6,000 if you are 50 or older) each year. But the limit for individual retirement account (IRA) contributions is only $6,000, plus another $1,000 if you are 50 or older.

If you buy your own insurance through an exchange, you might find a high-deductible health plan, known as an HDHP, much more affordable than a low-deductible plan. Of course, the same might be true for health insurance arranged through an employer.

David Mendels, director of planning with Creative Financial Concepts in New York, said that for people buying an HDHP through an exchange, an HSA is “an absolute no-brainer. You are going to get the tax deduction, you are still going to get the money, and you can get it out tax-free.”

There’s also the potential for free cash from your employer. Many match contributions into an HSA up to a certain limit. In its year-end HSA research report, Devenir (which provides investment services to HSA administrators) estimated that the average employer contribution to an HSA increased to $839 in 2018 from $604 in 2017.

Here’s how you avoid taxes when you take out the money

Once you are 65, you can withdraw money from your HSA for any purpose, rather than just to cover health costs. If you spend it on qualified health-related expenses, the withdrawal is tax-free, as it is at any age. If you take money out for another reason, you will have to pay income taxes.

You might even “reimburse yourself,” tax-free, for qualified medical expenses you had paid for out-of-pocket in earlier years. Not tapping your HSA for out-of-pocket expenses now means you can enjoy the benefit of tax-deferred growth longer while still claiming the benefits of tax-free health-related spending.

Unlike an IRA or 401(k) account, there is no required minimum distribution from an HSA at age 70 1/2. Considering how likely it is for you to have high medical expenses later in life, it is quite likely that some or all of the HSA money will never be taxed.

Ask yourself these questions

To participate in an HSA, you need to be enrolled in a high-deductible health plan, which means the annual deductible needs to be $1,350 for an individual and $2,700 for a family. The HDHP’s annual out-of-pocket maximum cannot exceed $6,750 for an individual or $13,500 for a family.

The higher deductibles and higher potential out-of-pocket maximum figures may be a little scary. However, this is where a potential opportunity lies.

Here are questions you should answer as part of your HSA decision-making process:

• How much would you save in premiums if you participated in a high-deductible health insurance plan instead of a more expensive plan with lower deductibles?

• Would this savings from lower premiums exceed the amount of the additional deductible?

• If you add in your employer’s contribution (if any) to an HSA, would that plus your premium savings exceed the additional deductible?

• How much higher would the maximum potential out-of pocket potential expense be with the high-deductible health insurance plan than with the low-deductible plan?

• Finally, you need to think about your particular circumstances. Do you or members of your family have serious ongoing medical conditions that might make the low-deductible plan the best one for you?

Mendels said it may also be important to think about treatments or doctors that may not be covered by your insurance. “There is a much broader range of expenses you can cover with the HSA than would be covered by virtually any medical plan,” he said. One example he named was a New Jersey resident who has a doctor in New York not covered by her insurance plan.

Once you answer these questions, you can decide for or against a HDCP/HSA combination.

If you are buying health insurance through an exchange, your decision points are pretty much the same, except that there is no employer contribution to the HSA.

Ken Roberts, an investment adviser with IWC Asset Management in Carmel, Calif., said that some people are reluctant to consider an HSA because they take a very simple approach: They want the lower deductible.

But, he added, “I like the HSA because if you don’t need it, it’s still savings that didn’t go to the insurance company. That gives you an edge.”

Dean Mason, CEO of HealthSavings Administrators, prefers to call a high-deductible health plan a “low-premium plan.”

Mason, a former CEO of UnitedHealth Group’s UNH, +0.51% Optum Health Bank (a health savings account administrator), said many employers “do a bad job explaining how much is coming out of your paycheck.”

“What you find in the low premium plan is that the savings you accrue on the premium tend to fully cover your out-of-pocket risk,” he said. This is, of course, more likely if your employer matches some of your HSA contribution.

HealthSavings Administrators is based in Richmond, Va., has about $818 million in assets under management and runs HSA plans for employers and individuals. The company is held by BluffPoint Associates, a private-equity firm in Westport, Conn.

Once you decide on an HSA

If you have an HSA through your employer, your contributions will probably be made with pretax dollars withheld from your pay, hopefully with a matching contribution from the employer. You can also choose to fund an HSA outside of work. This may be a good option if there is no matching contribution available or if you find your employer’s HSA plan too expensive or that its investment offerings too limited.

If you qualify for an HSA when buying your own health insurance through an exchange, you will need to go to an HSA administrator on your own to make contributions.

“On the most elementary level, just like with your 401(k), if you are going to participate, before you do, take a look at what the expenses are. A particular HSA may be so expensive that it is not worth doing,” Mendels said.

Not only do you need to know about an HSA’s administrative expenses, you need to know what investments, if any, will be available.

Eric Remjeske, co-founder and president of Devenir, pointed to HSASearch, a website run by his company, where you can compare HSAs’ administrative expenses and investment choices. If you click “all HSA providers” on the top left, you can see that scores of providers have no administrative fees, but the majority also have no investment options available. This means you would be following a FSA-like “save and spend” model, possibly wasting some of the benefits of your HSA. The site has various other tools you can use to compare HSAs if you are looking for your own provider.

If you enroll in an HSA through your employer, the plan administrator may place your money in a money-market fund (earning a very low interest rate) by default. One reason for this is that you may be required to build up a minimum cash balance before investing the rest of the money in mutual funds for long-term growth. This makes sense, because even if you are using your HSA a long-term investing vehicle, you may need to tap some of the money to cover out-of-pocket medical expenses at any time.

But the default choice means many participants will never change the investment selections for their HSAs. This can lead to a tremendous loss of potential investment returns over the years, or decades. A phone call to your plan administrator to discuss your investment options, and their costs, is time well spent.

In its year-end industry report, Devenir estimated that only 19% of HSA balances were invested as of Dec. 31, with the rest sitting in cash. Devenir also estimated that the number of HSA accounts increased by 13% during 2018 to 25 million and that total assets in HSA accounts grew by 19% to $53.8 billion.

HSA investment selections and fund fees

Mason touted the benefits of “investment-focused HSAs” that allow participants “first-dollar investing,” rather than requiring a cash balance to be accumulated first. At HealthSavings Administrators, participants have no minimum balances and can “invest in institutional-class funds right away, max out their contributions, and start accumulating assets,” he said.

“Those initial dollars make a difference when treating HSAs like the long-term investment vehicle they are,” he added.

The emphasis on institutional share classes is an important one for investors seeking those managers who stock-pick, or what’s called active management. Note that active managers on average struggle to outperform funds that passively track an index, especially over multiple years.

Your obvious path to the lowest expenses is to select broad index funds with low expense ratios. But if you want to diversify with active management, an institutional share class can have much lower expenses than a share class normally offered to individuals.

In addition to offering lower-cost institutional shares for actively managed funds, HealthSavings Administrators also offers some of the lowest-cost index funds through Vanguard, including the Vanguard 500 Index Fund’s Admiral shares VFIAX, +1.11%, which have annual expenses of only four basis points. 

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