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  • Fullah Kamara

Unlocking Healthcare Wealth: The Ultimate Guide to Tax-Savvy FSAs and HSAs


Introduction

Medical expenses are one of the leading causes of bankruptcies in the United States (https://www.abi.org/feed-item/health-care-costs-number-one-cause-of-bankruptcy-for-american-families). Navigating the landscape of healthcare expenses can be daunting, but understanding tax-advantaged accounts like Flexible Spending Arrangements (FSAs) and Health Savings Accounts (HSAs) can provide significant financial benefits. In this blog post, we'll delve into the details of FSAs and HSAs, exploring their tax advantages, rules, contribution limits, and offering practical examples to empower individuals to make informed decisions to optimize their healthcare finances.

Section 1: Flexible Spending Arrangements (FSAs)

Flexible Spending Arrangements (FSAs) are employer-sponsored benefit plans that allow employees to contribute pre-tax dollars from their paycheck to cover qualified medical expenses. Although employers may contribute to the account, FSA funds cannot be used to pay for health insurance premiums. Let's take a closer look at the tax benefits and rules associated with FSAs:



Tax Benefits of FSAs:

  1. Pre-Tax Contributions: Contributions to an FSA are deducted from the employee's paycheck before taxes are withheld, reducing their taxable income for the year.

  2. Excluded from gross income: The amount contributed by the employer on behalf of the employee are not included in gross income of the employee when filing the federal income tax return.

  3. Tax-Free Withdrawals: Funds withdrawn from an FSA for eligible medical expenses are not subject to federal income tax, Social Security tax, or Medicare tax.

  4. Advance withdrawal: Employees are able to withdraw funds from the FSA before their own contributions have been placed in the account.

  5. Higher Take-Home Pay: By contributing to an FSA, employees effectively increase their take-home pay since they are using pre-tax dollars to cover medical expenses.

Example: Let's say Emily, who is in the 24% tax bracket, contributes $2,500 to her FSA for the year. By doing so, she saves $600 in taxes ($2,500 x 24%).


Qualifying for an FSA

FSAs are plans established by employers. As such, they must be offered in conjunction with other employer-provided benefits as part of a cafeteria plan. Self-employed individuals are not eligible for an FSA.

When to contribute.

Employees can designate how much they will be contributing prior to the beginning of the plan year. Elections can be revoked or changed only if there is a change in employment status or family status as specified in the plan.

Rules and Limits:

  • Contribution Limits: The IRS sets annual contribution limits for FSAs. As of 2024, the maximum contribution limit is $3,200 per year per individual.

  • Use It or Lose It: One important rule to be aware of is the "use it or lose it" provision, which stipulates that any unused funds in an FSA at the end of the plan year may be forfeited. However, some plans offer a grace period or a carryover option to mitigate this risk. The maximum carryover allowed by the IRS for 2024 is $640.

  • Qualified Medical Expenses: Eligible expenses include deductibles, copayments, prescriptions, insulin, medical devices, and certain over-the-counter medications (https://www.healthcare.gov/glossary/flexible-spending-account-fsa/#:~:text=Allowed%20expenses%20include%20insurance%20copayments,t%20taxed%20on%20this%20money).

Section 2: Health Savings Accounts (HSAs)

Health Savings Accounts (HSAs) are tax-advantaged accounts available to individuals enrolled in High Deductible Health Plans (HDHPs). HSAs are tax-exempt trust or custodial account that can be set up with a qualified HSA trustee to pay or reimburse certain medical expenses. Here are the key points to know:

 

Eligibility and Authorization: To establish an HSA, you must be an eligible individual, and no permission or authorization from the IRS is required (https://apps.irs.gov/app/vita/content/17s/37_02_020.jsp?level=advanced).

Qualified HSA Trustee: A qualified HSA trustee can be a bank, an insurance company, or an entity approved by the IRS to be a trustee of individual retirement arrangements (IRAs) or Archer MSAs (Medical Savings Accounts).

Separate from Health Plan Provider: You can set up an HSA with a trustee that is different from your health plan provider.

Tax Advantages: Contributions made to an HSA can be tax-exempt, and the earnings in the account are not taxed. Distributions used for qualified medical expenses are also tax-free.

Ownership and Portability: You own the HSA, and it remains with you even if you change plans or employer or retire. Unused funds can be carried forward, and you can roll over funds from an Archer MSA into an HSA tax-free. Now let's look at the tax benefits:



Tax Benefits of HSAs:

  1. Contributions: Contributions to an HSA can be made by the participant or someone other than the employer. Contributions made by the participant or a third party are tax-deductible when filing the federal tax return, even if the participant does not itemize deductions on their 1040. Contributions made by the employer, including those made through a cafeteria plan, are excluded from the employee's gross income .

  2. Account Balance: Contributions to an HSA remain in the account from year to year until the participant withdraws funds. The account balance can accumulate over time.

  3. Tax-Free Earnings: Interest or other earnings on the assets in the HSA accumulate tax-free. This means that the growth of the account is not subject to income tax.

  4. Tax-Free Distributions: Distributions from an HSA are tax-free if used to pay qualified medical expenses. This includes expenses such as doctor visits, prescription medications, and hospital stays. However, if the distributions are not used for qualified medical expenses, they may be subject to income tax .

  5. Portability: An HSA stays with the participant even if they change employers or leave the workforce. It is not tied to a specific job or employer just like employee contributions made to a 401k plan.

Example: Jake contributes $3,000 to his HSA and invests it in a diversified portfolio. Over time, his contributions grow tax-free, and he uses the funds to cover medical expenses in retirement, avoiding taxes on both contributions and earnings.

HSA Qualifications

To be eligible for a Health Savings Account (HSA), individuals must meet the following requirements:

 

  • High Deductible Health Plan (HDHP): The individual must be covered under a high deductible health plan on the first day of the month. This means that the health insurance plan must have a higher deductible than traditional health insurance plans.

  • No Other Health Coverage: The individual must not have any other health coverage, with a few exceptions.

  • Not Enrolled in Medicare: The individual cannot be enrolled in Medicare, which is a federal health insurance program primarily for individuals aged 65 and older.

  • Not a Dependent: The individual cannot be claimed as a dependent on someone else's tax return, regardless of whether the other person actually claims them as a dependent.

 

There are a couple of additional considerations:

 

Last Month Rule: If an individual is considered an eligible individual on the first day of the last month of the tax year (December 1 for calendar year taxpayers), they are considered an eligible individual for the entire year.

Spouse with Non-HDHP Coverage: An individual can still be considered an eligible individual for an HSA, even if their spouse has non-HDHP family coverage, as long as the spouse does not cover the individual.

Rules and Limits

  • Contribution Limits: As of 2024, the annual contribution limit for individuals with self-only coverage is $4,150, and for family coverage, it's $8,300. Individuals aged 55 or older can make additional catch-up contributions (https://www.irs.gov/pub/irs-drop/rp-23-23.pdf).

  • Qualified Medical Expenses: Similar to FSAs, HSAs cover a wide range of qualified medical expenses, including deductibles, copayments, prescriptions, and certain over-the-counter medications.


Conclusion: Maximizing Tax Savings and Financial Wellness

By leveraging the tax advantages of Flexible Spending Arrangements (FSAs) and Health Savings Accounts (HSAs), individuals can optimize their healthcare finances, reduce taxable income, and build savings for future medical expenses. Understanding the rules, contribution limits, and investment options associated with FSAs and HSAs empowers individuals to make informed decisions aligned with their financial goals.

Consulting with a Certified Public Accountant (CPA) or tax advisor can provide personalized guidance tailored to individual circumstances, ensuring compliance with IRS regulations and maximizing tax savings. With careful planning and strategic use of tax-advantaged accounts, individuals can achieve greater financial wellness and peace of mind when it comes to managing healthcare expenses.

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