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Why You Should Use the HSA Instead of the HRA in 2018

Written by Ed Snyder, CFP® on .

couple on couch looking at laptop

Open enrollment is here. You know, that time of year where you make choices about your benefits at work? One area that I've noticed that people may want to take a little more time in comparing their options is in the health insurance plan that they choose. As an Eli Lilly employee you can choose from two plans; a Health Reimbursement Account (HRA) or a Health Savings Account (HSA). My experience has been that most people use the HRA. But I think you should do some analysis and consider whether the HSA might be a good choice for you and your family.

You may have heard about the HSA, but maybe you're not sure how it works or how to use it. HSAs are relatively complex and can be confusing. Is it affiliated with health insurance? Does it have anything to do with my retirement? Is it a bank account, an investment account? It can be all of these things.

HSAs are available to those that have high-deductible insurance plans. The money in the HSA can be used to meet deductible and other out-of-pocket health care costs. The beauty is that the money you put in your HSA goes in pre-tax, like the money you put in your 401(k). Investment growth and interest are tax deferred, and withdrawals spent on qualified medical expenses are also tax free. I call this the trifecta of tax savings. This triple tax benefit increases your buying power compared to using after-tax money.

For example, let's say you had $1,000 in medical expenses for the year.  If you pay those expenses from money that you had in your HSA, you would be paying them with money that had not been taxed.  But, if you did not have an HSA, and paid the expenses from after-tax money (assuming the 25% federal income tax bracket and 5% state income tax), your $1,000 in medical expenses would actually cost you $1,428.57. Why? Here's the math. $1,428.57 - $357.14 (25% federal income tax) - $71.43 (5% state and county income tax) = $1,000 after tax. You can see the year-to-year savings potential of an HSA from this simple example.

You can also use an HSA for long-term retirement savings. Money in your HSA rolls over at the end of the calendar year. They are not "use-it-or-lose-it" like Flexible Spending Accounts Health Reimbursement Accounts. Health Savings Accounts are portable – that means you take it with you when you leave your employer. They are individually owned and not tied to employers. When you retire or leave your employer for any other reason, your HSA goes with you.

To utilize an HSA as a retirement tool you can pay your current medical expenses out of pocket, while making contributions to your HSA. You can let the HSA balance grow, much like you would an IRA or 401(k). The maximum amount you can contribute to an HSA for 2018 is $3,450 for individuals or $6,900 for families.

Let's assume that a worker is 40 years old and works until they are 65 years old and contributes $6,900 each year to his or her HSA. (Lilly contributes $1,600, so the employee contribution is $5,300) We'll assume a 4% average rate of return on the money invested in the HSA. At age 65, the HSA balance would be over $290,000. As long as that money is used for qualified medical expenses it will not be taxed. A recent estimate by Fidelity[i] indicates a couple retiring this year will need $275,000 to cover health care costs in retirement. I think you will likely have plenty of health care costs that you can use that money for.

Withdrawals from an HSA that are not used for qualified medical expenses are taxed at your income tax rate, plus a 20% tax penalty. However, once you reach age 65, distributions are never subject to penalty. You can use the money for whatever you want, the penalty does not apply. If you do not use it for qualified medical expenses, it will be taxable at your income tax rate. This is the same way your 401(k) or a deductible IRA would be treated for tax purposes. So, if you can use it after age 65 for medical costs you'll get the most benefit but even if some of it is used for non-medical costs, it still has a great benefit, like your IRA or 401(k).

So, what is a qualified medical expense? Generally, qualified medical expenses are those that qualify for the medical expense deduction. This includes most medical, dental, vision and chiropractic expenses. You may take tax-and penalty-free distributions to pay for your spouse or dependents' medical expenses as well as your own. You can even take a tax- and penalty-free distribution this year to reimburse yourself for medical expenses in a previous year, as long as the expenses were incurred after your HSA was established.

You may not have 25 years to save in an HSA like the worker in my previous example. Maybe you're 5 or 10 years away from retiring. The HSA may still make sense for you. When you reach age 55 you can contribute an additional $1,000 per year to your HSA, for a total of $7,900 (Lilly contributes $1,600. The employee contribution is $6,300). If you contributed that for 5 years and it grew at 4% it would be worth $44,500. And remember, you didn't pay tax on that money. $44,500 can pay a lot of health care expenses during retirement with tax-free dollars. If you're 5 to 10 years from retirement, you still have time to benefit from using an HSA.

Last year, 26 percent of employers helped offset the costs of HSA contributions by making contributions to employee accounts. Those contributions averaged $868, according to Devenir, a consulting firm that works with HSA providers and employers.[ii] Eli Lilly is one of those generous employers. In 2018 they will contribute $800 for an individual or $1,600 for a family.

But what about the actual health insurance part? How do the HSA and HRA compare as far as paying for medical expenses? Many people look at the coinsurance of 10% for the HRA and 20% for the HSA and assume that the HRA must be better. This is not necessarily true. Because of lower premiums and lower deductibles for the HSA and the out-of-pocket maximum limits, the HSA can often be the more cost-effective choice.

I've analyzed what your costs would be under both the HRA and the HSA for 2018. These numbers were run assuming a family of four or more with the Lilly employee salary between $100,001 and $150,000, using the maximum individual out of pocket amounts, not family. The premiums, annual deductibles and Lilly's contribution all change based on the number of people covered, and the coinsurance maximums and out-of-pocket maximums change based on your salary, so your situation may be different. I'm happy to run numbers for you if you want to compare. For this first example, we are assuming that the family spends $2,000 for the year in medical expenses in addition to the premium.

HRA – Health Reimbursement Account

Premium                          $5,064 ($211 per pay period)

Medical Expenses            +$2,000

Costs                                 $7,064

Lilly's Contribution            -$2,000

Your Net Cost                   $5,064

HSA – Health Savings Account

Premium                          $4,080 ($170 per pay period)

Medical Expenses           +$2,000

Costs                                $6,080

Lilly's Contribution           -$1,600

Your Net Cost                  $4,480

The HSA would cost $584 less for the year than the HRA in this situation.

What if your medical expenses were much higher for the year though. Let's assume a family member had a surgery that was very costly. Let's assume that your expenses were $40,000. How would that be covered by each plan and what would your total costs be?

HRA

Premium                         $5,064 ($211 per pay period)

Medical Expenses          +$6,500 (deductible + coinsurance = $6,790. Annual out-of-pocket max = $6,500)*

Costs                              $11,565

Lilly's Contribution          -$2,000

Your Net Cost                 $9,564

*$40,000 - $3,100 deductible = $36,900 X 10% coinsurance = $3,690

HSA

Premium                        $4,080 ($170 per pay period)

Medical Expenses         +$6,300 (deductible + coinsurance = $10,160. Annual out-of-pocket max = $6,300)*

Costs                            $10,380

Lilly's Contribution         -$1,600

Your Net Cost                 $8,780

*$40,000 - $2,700 deductible = $37,300 X 20% coinsurance = $7,460

In this case, the HSA would cost $784 less for the year.

I also ran the numbers on having $10,000 in medical expenses for the year – somewhere in between the previous two examples. Sparing you the details, the HSA would be $214 cheaper for the year.

These examples do not take into account using the Health Savings Account for the year-to-year tax savings. If you contributed $5,150 to your HSA for the year, you would have a tax savings of $1,546. (25% federal income tax, 5% state income tax). They also do not include how the balance of the HSA can grow over time. Want to see how much you could save in income taxes and how much your contributions could grow to? Check out https://mybenefitwallet.com/resource-center-hsa-calculators.html

Often people ask me how they can save more money for retirement. They are maxing out their 401(k) contributions and their Roth IRAs, but want to save even more. An HSA is an often- overlooked tool for this. And it's a tax savings trifecta! The money goes in pre-tax, grows tax-deferred and comes out tax free, as long as you use it for health care expenses.

Open enrollment is a busy time and there are a lot of choices to be made. Many times, it's easier just to continue doing what you've been doing. Hopefully this article can help you take some time to consider whether the Health Savings Account might be a good option for you. Want some help running the numbers or have questions? Call or email us.

Thanks for reading!

[i] http://money.cnn.com/2017/08/24/retirement/health-care-cost-retirement/

[ii] http://www.wealthmanagement.com/retirement-planning/hsas-spend-or-save-it

The preceding examples were hypothetical in nature and are for illustrative purposes only. No specific investments were used in these examples. Actual results will vary. Past performance does not guarantee future results.