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Health savings accounts are becoming common at the workplace, but few people are allowing their funds to grow, which many advisors say is the smarter move.
Rising health-care costs have pushed employers to use or at least consider high-deductible health plans at the workplace. Employees in these plans have access to tax-advantaged health savings accounts (HSAs) to pay for qualified medical expenses.
To qualify for an HSA, your health plan has to be what's considered "high-deductible," meaning $1,300 out-of pocket for individual coverage and $2,600 for families. The maximum amounts for these plans are $6,550 for individuals and $13,100 for families in 2016.
There were 18.2 million HSAs as of June 30, up 25 percent from a year earlier, according to HSA consultancy Devenir.
HSA assets are growing as well. They hit $34.7 billion at the end of June, 22 percent higher than the previous year, Devenir found.
Despite the popularity, many holders are spending the money instead of allowing it to accumulate. In the first six months of 2016, $16.7 billion went into HSAs, and holders withdrew $11.8 billion, according to Devenir.
"People think, 'I put the money in there for health expenses. I have a health issue, so I'll use the money now,'" said Jeffrey Levine, chief retirement strategist at Ed Slott & Co. "That isn't the most tax-efficient use."
Health savings accounts offer three major tax benefits: The contributions you make are tax deductible, your account will grow tax free and withdrawals are tax free as well as long as it's for qualified medical costs.
You and your employer can contribute up to $3,350 to the HSA in 2016 if you have individual coverage, or $6,750 for family plans. You can add a catch-up contribution of $1,000 if you are at least 55.
"If you let the money grow, you would get the deduction for the contributions, taxes on growth would be deferred, and withdrawals are tax free at a time when you're likely to incur medical expenses at a greater frequency," said Levine.
For example, a 65-year-old couple retiring this year will need an estimated $260,000 to cover health-care costs plus $130,000 for long-term care expenses, according to Fidelity.
Another benefit of using an HSA is that withdrawals are tax-free for qualified medical expenses.
While you can take advantage of those tax-free benefits at any time, to get a bigger bang for your buck, you might want to let your HSA grow and use it when you're retired. HSA funds can cover prescription drugs, medical supplies and even long-term care insurance premiums.
One snag: You cannot use HSA dollars to pay for Medigap premiums, according to the IRS, but Medicare Advantage premiums are covered.
Here's another case for using the HSA to cover retirement health-care expenses: The medical expense deduction will be less valuable for those who are over 65, starting with their 2017 tax return.
If you itemize, those 65 and older will need out-of-pocket health-care costs equal to at least 10 percent of their adjusted gross income in order to qualify for a medical-expense deduction. In previous years, that hurdle was 7.5 percent.
Instead, tap the HSA on a tax-free basis for these costs.
You can pass your HSA to your spouse if you die. He or she can use it for qualified medical expenses.
The news isn't as good for other beneficiaries of HSAs, however.
For nonspouse survivors, the account loses its HSA status and its fair market value becomes taxable to the beneficiary in the year you die. If your estate is the beneficiary, the account's value is included on your final income tax return.
"We haven't had an issue with large HSA accounts, but could you see it? Absolutely," said Levine.
"If you're getting close to the end, you would want to start pulling from that account," he said. "Don't leave it to a nonspouse beneficiary."