In addition to your health insurance premiums, your employer may offer a flexible spending account (FSA) or health savings account (HSA) to help offset your out-of-pocket costs. There are some key differences between these two options you should know about.
Flexible Spending Account
FSAs allow you to pay for healthcare costs at a discount. For example, let’s say you have to pay around $1,000 a year on medication. Typically, you would pay those expenses out of pocket from your checking account. That means you are paying the bill with money left after you have paid taxes (a.k.a. after-tax dollars). But if you were to pay from your FSA, you would pay with pre-tax money, similar to your 401(k) contribution. However, unlike your 401(k) when you use money from your FSA, you don’t get taxed on that money.
Let’s say you are in the 20% marginal tax bracket. When $1,250 is taxed, you receive a net of $1000 in your checking account If you use an FSA, you would either have $250 more to use to offset health expenses or you could save less to cover the $1000 medication costs referenced earlier.
An FSA can be funded by you, your employer or a combination of both. No matter how it’s funded, the government caps the amount. In 2019, the cap is $2,700.
The funds must be used in the calendar year that they are saved. If you are concerned about having leftover funds, your employer might allow you to rollover up to $500 into the next year’s funds. The permitted rollover amount is up to them, so it could end up being less than $500, or they might not let you rollover any of your unused funds. Even with some money left unused, the tax benefits can still leave you ahead of the game. Spend some time to look at your previous year’s costs and do a projection of this year’s costs. That should help you determine how much you should accrue into that account.
Health Savings Account
An HSA allows you to save and potentially invest untaxed dollars like you would in an IRA or 401(k)to pay for healthcare costs. If you invest them and wait to use them in retirement, you can consider them retirement HSA. In order to qualify for an HSA, you must be enrolled in a qualifying high-deductible healthcare plan. That deductible may be as low as $1350 for single coverage or $2700 for family. If your employer does not offer one directly, you can find an independent provider, either with or without a financial advisor. All providers don’t offer the same opportunities, such as investing your first dollar.
Why would you wait rather than use that money now? The “2017 Retirement Health Care Costs Data Report” by HealthView Services estimates healthcare costs in retirement will exceed $400,000 for an average 65-year-old couple. They expect lifetime retirement healthcare premiums for Medicare Parts B and D, supplemental insurance and dental insurance to be $321,994 in today’s dollars. After accounting for deductibles, copays, hearing, vision and dental out-of-pocket costs, that brings the total retirement healthcare costs to $404,253.
Would you rather pay for healthcare expenses from a 401(k) or IRA, which you will have to pay taxes on, or from accounts that have never been taxed? Wouldn't you rather contribute a dollar and then, through the magic of compounding, see that dollar grow to two dollars, three dollars, or even more? I hope that’s what you expect to happen with your 401(k), IRA and Roth IRA accounts. In 2019 the maximum contribution to an HSA is $3,500 for a single person and $7,000 for a family. However, if you or your spouse is 55 years of age or older, you can make an additional contribution of $1,000 per year. As with the FSA, your employer can contribute to an FSA, but they are not required to do so.
This illustration may clarify. Let's say you are 40 years old and you qualify for the family contribution of $7,000. Further, let’s assume you don’t expect to have high medical bills for 30 or 40 years. Assuming you aim to retire at age 72, and you have a 6% rate of return on your initial contribution, whatever you put in now would double in 12 years to $14,000. In another 12 years it would double to $28,000, and by age 76 would double again to $56,000. That means you can pay for $56,000 of health expenses with only $7,000 of your own money. If you save the same amount in your 401(k), you would have to pay taxes on the $56,000, meaning that $56,000 withdrawal would be added to your income for that year, which could potentially push you into an even higher tax bracket. Assuming you would be in a 20% marginal tax bracket, that means the $56,000 only represents $44,800 of health care cost purchasing power. That is just from one year of health savings! You can continue to contribute until you retire, or until the health savings rules change (if they change).
While you may not experience joy when thinking about paying for healthcare costs, hopefully joy comes from saving on taxes and putting more money in your pocket.
