Taxes

The Health Care Savings Face-Off: HSA Vs FSA

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Both HSAs and FSAs provide tax savings on health care costs. Depending on your personal and family needs, one might be better than the other in any given year. This decision can seem overwhelming for most of us. With a little understanding of how each account works and the strategies behind them, you too can maximize your tax savings and better prepare for the future. Let’s break down how each account works, their pros and cons, and situations to be aware of when considering a switch.

THE FSA

What is it? An FSA (flexible spending account) is an employer-provided benefit that provides a tax-advantaged way to save and pay for qualified medical expenses incurred in a calendar year. One of the key benefits of an FSA is that the funds contributed to the account are deducted from your earnings before taxes, which lowers your taxable income and hence reduces your annual tax liability. In addition, you pay no taxes on the distributions for qualified medical expenses.

Contributions: The IRS sets the contribution limits every year. For 2022, the contribution limit per employee is $2,850. You can only change your contributions at open enrollment or with a change in employment or family status. Your contributions are automatically deducted from your paycheck and are made during the calendar year. Employers can contribute, and their contributions do not count towards the annual maximum.

Who can use the FSA funds? FSA funds can be used to cover qualified medical expenses incurred by you, your spouse, and dependents who are claimed on your tax return. If a dependent earns gross income in excess of $4,300, files a joint return, or can be claimed as a dependent on someone else’s return, as per the IRS, they are not eligible.

Is there a carryover? The IRS allows for up to $570 to be carried over into the next plan year, but your employer must allow for this feature. Any dollars above $570 are forfeited. Another option that employers can offer is a 2.5-month grace period into the new year to spend any leftover funds. Employers can offer either option but not both.

A best practice is to only allocate dollars over and above the carry-over limit that you think there is a high probability of using. Be sure to carefully read through your employer-offered health insurance plan documents to learn more about the cost of copays, coinsurance, and any additional items that can be covered with FSA dollars. Otherwise, you’ll find yourself shopping the FSA store for eligible items to stock up on before the year is up, or you’ll lose those dollars.

THE HSA

A health savings account (HSA) is a tax-advantaged account that individuals covered by a high-deductible health plan can use to help save and pay for qualified medical expenses. For 2022, the IRS defines a high deductible health plan as any plan with a deductible of at least $1,400 for an individual or $2,800 for a family. An HDHP’s total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) can’t be more than $7,050 for an individual or $14,100 for a family. (This limit doesn’t apply to out-of-network services.)

Like the FSA, a key benefit of the plan is that you can set aside pre-tax money for medical expenses. The HSA goes further in that the money in the account can be invested and grow tax-deferred, all funds can be taken out without taxes and penalties if used for qualified medical expenses, and funds that are contributed are yours forever (There is no use it or lose it provision.)

Contributions: For 2022, the maximum contributions (inclusive of employer contributions) are $3,650 for single coverage, $7,300 for family coverage and $1,000 for catch-up contributions for those age 55 and older. You have until the tax filing deadline, April 15, 2023, to make your 2022 contribution. The contribution can be made from your paycheck (as a pre-tax contribution) or directly with a check or electronic transfer (as a tax-deductible contribution).

To qualify for a contribution, you must be covered under a high deductible health plan (HDHP), with no other health care coverage (except what is allowable per IRS rules), not be enrolled in Medicare, and cannot be claimed as a dependent on someone else’s tax return.

Who can use the HSA funds? The funds can be used for yourself, your spouse (regardless of whether you file jointly or separately), any HSA-eligible dependents you claim on your tax return (your children, or a qualifying relative dependent) and any children who are claimed on your ex-spouse’s tax return. This means you can reimburse yourself for qualified medical expenses with tax-free money from your HSA whether the person above was covered under your HDHP or not.

Is there a carryover? Any unused balances roll over into the next year indefinitely. There is no “use it or lose it” provision.

HOW DO I CHOOSE?

First, do the math: Most employer benefits administrators now offer some type of healthcare evaluation tool such as ALEX, so be sure to check with your HR or other benefits administrator as the first step since this can make the math a lot faster and easier. You can read more on how to choose a health care plan here.

Your aim is to calculate how much you can expect to pay for each plan in yearly premiums, deductibles, and out-of-pocket costs while also factoring in any employer contributions. Be sure to consider a base and a conservative scenario for health care usage. Start with the premium cost, the annual deductible, expected medication costs, typical over-the-counter pharmacy spending and anticipated doctor’s visits (especially surgery or birth needs). You can use this resource to better understand key health insurance terms. You can then compare the total expected out-of-pocket costs for each plan.

Second, consider the savings vehicle in the equation: Most tools don’t factor in the tax savings and employer contributions, so the next step is to incorporate the additional immediate tax benefits that you’ll derive from each plan. Remember that the FSA is “use it or lose it” so put in only what you are confident you’ll use within that carryover amount range ($570 for 2022 if your employer allows).

As an example, say you were to contribute (and use) $2,850 for 2022. If you were in the 24% marginal tax bracket, that would mean $684 dollars of federal tax savings ($2,850 * 24%). If those savings in addition to the expected out-of-pocket costs for that year are best for your family’s budget and needs, then go the FSA route. (Typically, the higher the medical needs, the cheaper it might be to go with a lower deductible plan and maximize the FSA).

Similar math would apply to the HSA. Based on your expected medical expenses, premiums, deductibles, employer contributions and tax savings, it might make sense to go the HSA route. (Typically, a person or family that expects to have minimal health care needs for a given year will save more money and benefit more from the higher tax savings and opportunity to leverage the HSA as a medical expense/retirement saving vehicle.) You can learn more on how to leverage the HSA for the present and the future here.

What are the main implications of switching plans?

If switching from an FSA to an HSA with the same employer:

You remain covered by your FSA during the full FSA plan year even after you spend down your entire election or if you enroll in an HSA-qualified plan in the middle of the year. As a result, you can’t open and contribute to an HSA during any month that you participate in a general FSA even if you’re enrolled in an HSA-qualified medical plan and meet all other eligibility requirements. You would need to wait until the beginning of the next plan year to begin your HSA savings. If you move to an HSA-eligible plan, you will need to spend down the entire FSA by the end of the plan year in order to fund that HSA in the new plan year. For example, if the plan year coincides with the calendar year, that first day would be January 1 so you would want to spend down your entire FSA election balance and file for all reimbursements before December 31st.

Note that some employers offer a limited-purpose health FSA (LPFSA), which limits reimbursement to eligible dental and vision costs. This LPFSA is allowed with an HSA and can offer additional tax benefits. Some employers may allow balances to roll over into a limited-purpose health FSA during the carryover period so that it can be used alongside an HSA. You’ll want to verify this as it is a plan-specific feature.

Switching if changing employers?

You are ineligible to contribute to an HSA if you have “other coverage” that is not an HDHP. An FSA counts as “other coverage,” but only while you are covered. If you terminate employment with employer A, you will need to determine if your FSA coverage ends with termination or after a certain grace period or some other provision that is particular to your benefit plan. You will want to confirm this with your previous employer so that you don’t run into any issues with the IRS in the future. Once you confirm when your coverage officially ends, then you will be able to contribute to an HSA.

Which is the best?

As you can see, the answer depends on your needs and personal financial situation. Both accounts help manage your out-of-pocket medical expenses but with different stipulations that can make one better than the other in any given year so be sure to do the math and factor in the premiums, deductibles, and out-of-pocket costs inclusive of employer contributions and savings from using the respective accounts. That way, you can make a more informed decision that can make a difference both now and in the future. In my next post, I’ll weigh in on some unique planning situations that involve spouses, dependents, and domestic partners so that you have a better idea of how to maximize each option in those situations.

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