Finance Tax Time

A taxpayer who is covered by a high-deductible health insurance policy may establish and contribute to a health savings account (HSA). The contributions the taxpayer makes are deductible in calculating adjusted gross income, so a taxpayer does not have to itemize deductions on Schedule A of Form 1040 to receive the deduction. Contributions made by an employer are not taxable to the employee.

For 2006, for individual coverage, a high-deductible policy must have an annual deductible of at least $1,050. For 2006, for family coverage a high-deductible policy must have an annual deductible of at least $2,100. A plan may have a lower deductible for preventive care. The annual out-of-pocket expenses are limited to $5,250 for an individual or $10,500 for a family.

The maximum monthly contributions an individual may make to an HSA in 2006 are the lesser of 1/12 of the deductible or $2,700. The maximum monthly contributions allowed to an HSA for a family plan in 2006 are the lesser of 1/12 of the annual deductible or $5,450. Individuals who are age 55 or older may contribute up to an additional $700 in 2006, $800 in 2007, $900 in 2008, and $1,000 in 2009 and later years.

Distributions from the HSA used to pay medical expenses, other than most health insurance, are not taxable. The medical expenses may be those of the taxpayer, the taxpayer’s spoouse, the taxpayer’s dependents, and certain individual who would be dependents except that they failed certain of the requirements for being a dependent.

If the taxpayer receives a distribution from the HSA and it is not for medical expenses, the distribution is taxable. If the taxpayer receives a distribution from an HSA for other than medical expenses, the distribution is taxable and the taxpayer must pay a 10-percent penalty unless the taxpayer is age 65 or older, disabled, or dead.

Medical expenses include optical, dental, and certain non-prescription drugs as well as expenses for physicians, hospitals, prescription drugs, and other traditional medical expenses. A taxpayer may not pay for a medical expense from an HSA and also deduct the same amount as a medical expenses on Schedule A of Form 1040.

Special rules apply to married taxpayers where each has health insurance. If only one spouse has family health insurance, both spouses are deemed to have family coverage. if both spouses have family health insurance under separate plans, the law treats each spoouse as having a family policy with the lower deductible.

Taxpayers who are interested in the tax benefits of an HSA should consult a competent tax professional and a knowledgeable insurance agent.

Alan D. Campbell is a CPA in Arkansas and Florida and is self-employed primarily as an author of tax publications. He earned a Ph.D. in accounting with an emphasis in taxation from the University of North Texas. He is also admitted to practice before the United States Tax Court. He has published numerous articles on tax topics in professional journals. He is the co-author of the book Tax Strategies for the Self-Employed and the revision editor of CCH Financial and Estate Planning Guide, 15th edition. For more tax savings strategies, please see his blog: http://taxsavingsstrategies.blogspot.com

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Concerned about the high cost of healthcare? Worried that your insurance doesn’t cover all your costs? Fortunately, a partial solution may be just around the corner. Since January 2004, taxpayers have had a tax savings tool called Health Savings Accounts, or HSAs. These HSAs may solve many of your healthcare cost problems.

How an HSA Works

In a nutshell, HSAs work like this. You buy a specific type of major medical, or catastrophic coverage, insurance called a High Deductible Health Plan. (This special HSA-compatible insurance is also known by the acronym HDHP.) Then, you annually contribute up to roughly $5,100 for a family and up to $2,600 for an individual–to a special health savings account. (Note that slightly higher deductions are available to taxpayers over the age of 55. Also, annual deductions are indexed for inflation.)

How You Save Taxes with HSAs

HSAs work because you get a tax deduction for the money you contribute to the health savings account. However, as long you spend the money in the account for eligible healthcare expensespretty much anything reasonableyou aren’t taxed when you withdraw the money. Note that HSAs deductions are not limited by taxpayer incomes.

In effect, the HSA makes all or most of your uncovered healthcare expenses fully deductible. This is a big deal because for most people, healthcare expenses are not deductible.
Just to put the value of an HSA into perspective, a family can save from $500 to as much as $1750 annually in income taxes by using one of these accounts. The final savings, predictably, depend on family income and the state where the family lives.
One other thing.

Don’t confuse HSAs with the old style Flexible Spending Accounts, or FSAs. With FSAs, you lost the money you didn’t spend by the end of the year. With HSAs, you don’t lose the money. The unused balance just carries forward to the next year.

Aren’t Medical Expenses a Tax Deduction Anyway?

No, not really. For most people medical expenses are not a tax deduction. Here’s why. Healthcare expenses do count as an itemized deduction for people who don’t use the standard deduction. However, only the portions of one’s healthcare costs that exceed 7.5% of adjusted gross income get deducted. That means that most people never get to use their healthcare costs as tax deductions because their healthcare costs don’t cross the 7.5% threshold.

Another Benefit: HSAs May Also Save Premiums

HSAs sometimes produce another economic benefit. The HDHP insurance itself may save people money because they buy less insurance. This is especially true for people who aren’t already using major medical insurance.

How to Set Up a Health Savings Account

HSA accounts aren’t difficult to set up. Essentially, you do just two things. (1) Get medical insurance that qualifies as an HDHP, and (2) Open an HSA account with a bank that offers HSAs. Your current medical insurance provider is a good place to start your search for HDHP insurance. You can also check with your state’s Blue Cross or Blue Shield insurer.

Three Warnings about HSAs

For what it’s worth, I am now using an HSA myself. (I got my HDHP from Premera Blue Cross and use an HSA account from HSA Bank.) But let me also share three caveats: First, obviously, you never want to cancel one insurance policy until you’re sure you have a replacement policy. Second, you do need to be careful about the fees associated with the HSA “bank account,” so shop around. Third, if you withdraw money from an HSA for something other than a valid medical expense, the withdrawal is taxable and subject to a 10% penalty.

Redmond WA accountant Stephen L. Nelson is the author of both Quicken for Dummies and QuickBooks for Dummies and an adjunct tax professor for Golden Gate University’s graduate tax school.

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