It’s no secret that health care is expensive. According to a recent study, a 65-year-old couple will pay $404,253 (which is $607,662 in future dollars) for total lifetime health care costs.1 Clearly, medical bills are a major expense category in most household budgets. It pays to look for ways to manage these expenses.
One strategy is to use tax-advantaged dollars to pay for medical costs. Two popular options are flexible spending accounts (FSAs) and health savings accounts (HSAs). Both types of accounts let you save a portion of your income before taxes to pay for qualified health expenses such as co-pays, deductibles and prescription drugs. FSAs and HSAs have different eligibility rules, benefits, and restrictions, however. Pay close attention to the details to determine which one might be best for your needs.
Flexible spending accounts.
An FSA is essentially an employer-sponsored benefit that helps pay for medical expenses. During open enrollment period, you commit to contribute a certain dollar amount to your FSA for the upcoming year. For 2018, the maximum amount you can choose is $2,650. The company puts the full amount you selected into your FSA on January 1 — and then you pay it back with automatic deductions from your paycheck over the rest of the year.
Contributions to your FSA are pre-tax, like the money you put into your 401(k). This gives you two benefits. First, you’re paying for qualified health care expenses for yourself, your spouse, and your eligible dependents with pre-tax dollars — which also reduces the amount of taxes taken out of your paycheck.
Note, however, that if you don’t spend all the money in your FSA by year-end, you may have to give up what’s left over. Some employers will allow you to roll over $500 to the following year or give you a 2.5 month “grace period” to spend anything left — but neither of these are guaranteed, so be sure to check the terms of your company’s FSA plan. Also, if you leave your job during the year, you may lose any unspent FSA funds, depending on the terms of your employer’s plan.
One advantage of an FSA is that your total contribution amount becomes available for spending on January 1 because your employer puts in the full amount at the beginning of the year. Let’s say you commit $2,650 to your FSA during open enrollment. You could spend the entire $2,650 in the first month of the year even though you’ve only paid back a small part of that amount. This could be a big help if you have a major medical procedure scheduled in January, for example.
Health savings accounts.
An HSA is a personal savings account earmarked for healthcare expenses. Unlike an FSA, you own and control the money in your HSA. You may also be able to invest the money in your HSA just like you would a 401(k) or IRA — which is also different from an FSA. Plus, you can take the balance with you if you leave your employer. You can also put more money into an HSA — up to $3,450 a year for individuals or $6,900 a year for families in 2018.
There’s no deadline for spending HSA funds. Each year’s contributions can be rolled over to the next year. For this reason, some people fund an HSA during their working years and use the money to pay for medical expenses in retirement, when they’ll need it the most. Since money in an HSA may be invested and isn’t tied to an employer, it can grow over time and be useable whenever you need it — whether it’s during your working years or in retirement.
Taxes are another major advantage of HSAs. They offer a triple advantage:
- Contributions can reduce current taxes.
- Investment earnings grow tax-deferred.
- Withdrawals (which include both contributions and earnings those contributions have made) are tax-free if used for qualified medical expenses.
So, what’s the catch? Notably, not everyone can open an HSA. To be eligible, you must be enrolled in a high-deductible health insurance plan. Specifically, in 2018, your deductible must be at least $1,350 for individual coverage or $2,700 for family coverage.
Understanding the differences.
These accounts can save you a lot of money if you use them wisely. But you generally have to choose between them. If your employer allows it, you may be able to open a limited purpose FSA along with your HSA — but it can only cover dental and vision services not already covered by your HSA. So essentially, you have to decide which one to focus more of your resources and attention on. Take a look at the differences in the comparison table below to help decide which type of account fits your lifestyle, health care spending, and long-term financial planning needs.
Making your decision.
Still not sure what’s best for you? Ask yourself the following questions:
Is a High-Deductible Health Plan right for me and my family? It’s a requirement if you’re considering an HSA, but you need to be prepared to cover medical expenses up to the deductible. Planning your HSA contributions wisely can help protect you from unexpected expenses.
How will I pay for healthcare in retirement? If you don’t have a plan in place, having an HSA can be an invaluable part of your financial plan to pay for health care expenses once you retire. An FSA is only helpful for the short term.
What health care expenses are on the horizon for me and my dependents? If you have short-term medical needs, an FSA can help cover those expenses up front at the beginning of the year. However, if you’re not enrolled in a high deductible health plan, your monthly health insurance premiums will most likely take a bigger bite out of your paycheck. And if you don’t anticipate having a lot of health care needs in the year ahead, that means you could be paying for coverage you don’t need.
Will my employer make contributions to either of these accounts? Some employers will encourage you to participate in one or both accounts by making additional contributions based on certain criteria that’s specified in your plan. In some cases, an employer could make contributions to employees with an HSA, but not employees with an FSA. Be aware, however, that your employer may have certain requirements, such as a health screening, before they make contributions to either account. Do your homework to understand how your plan works and if there’s more money at stake than what comes out of your own paycheck.
Health care can be pricey — but FSAs and HSAs can help make the most out of your money and cover health care expenses in a cost-effective way. Research your options and run calculations to determine if an FSA or HSA makes sense for you. A financial advisor can help you understand how these options may fit in with your overall tax strategy. Planning ahead for health care costs can go a long way in setting you up for overall financial success both now and down the road.