What if there was an account to which you can contribute money to before tax, invest and let the money grow tax-free and then spend that money tax-free? This looks like a fantasy setup but it is not, and you should know about it.
Consumer-Directed Health Plans (CDHP) combine a High-Deductible Health Plan (HDHP) with an investment account, also called an HSA or a Health Savings Account.
Confused? I know but that is our health insurance system, though I’d try to simplify as best as I can.
With traditional employer-provided health insurance plans, you’d pay a $20 or $30 co-pay every time you go see a doctor.
But with CDHP, you pay the full retail cost as if you do not have insurance. That is, the insurance company does not come to your rescue until you have paid say about $3,000 out of pocket total on medical expenses for you and your family in a given year. Once that limit is exhausted, another slab kicks in for say the next $2,000 where you split the cost with your insurer. The amounts can vary from employer to employer but that is the general theme.
But once the $5,000 total annual limit is reached, you have no more healthcare-related expenses for that year. The insurance company picks up the entire tab from that point on.
So, what made these plans (CDHP) come about? Choice and to some extent, necessity. They are a great deal for the employer, almost always a great deal for you and certainly a decent deal for the health care system in general.
Because with CDHP, you are signing up to take the initial cost hit which then means insurance premiums are lower as compared to traditional health insurance plans. And since employers split the cost of insurance with you, they love you for that even more.
But because you are willing to take the initial cost hit, you are more likely to price compare. Or at least be aware of the grossly inflated costs you pay for pretty much everything healthcare so there is this vague promise that this will somehow instill some cost discipline in the system.
And you’d tend to use healthcare less when you know you are going to incur that gigantic cost hit every time you go see a doctor. That even knowing that your total all-in cost in any given year is almost guaranteed to be lower with CDHP than with traditional health insurance.
But using healthcare less is both good and bad. Good because you won’t be going running to your doctor for every itty-bitty stuff. Bad because who knows whether that itty-bitty stuff that pains you is truly itty-bitty.
We use CDHP in our family but of all the things that we economize on, this is one thing where we try not to. If it pains, it is time to go get it checked.
Talk about checkups, preventive services are covered at no cost with CDHP, so it is dumb to skimp on things like annual physicals etc. I’d check with your employer though to get a rundown on what is covered and what is not.
What else is in it for you with these plans besides lower premiums? Access to an HSA, an account to which you contribute money every pay period before any taxes are taken out. You can then use that money to pay for qualified medical expenses.
But the money went in pre-tax and when you spend it on healthcare, you get the entire amount back. So, in theory, the money never got taxed.
Plus, to incentivize participation in these plans, your employer might match your contributions to the HSA so more tax-free money to spend.
But it gets even better. Say you contribute $3,000 to an HSA in a given year but only end up spending $1,000. The $2,000 that remains can be invested in a portfolio of stocks and bonds just like you’d do in your 401(k).
Do that for a few decades and you’ll be sitting pretty with a nice pile of stash, right in time for retirement when you’d need healthcare the most. And all that growth happens tax-free.
The money hence went in pre-tax, grew tax-free and is spent tax-free when used for healthcare. This money is the only money in our system that never gets taxed.
There is of course a limit to how much you can contribute to the HSA account each year but it is high enough to accumulate a decent chunk (if not spent) to cover most or all your healthcare-related expenses in retirement. And you know those expenses are coming.
In fact, we don’t spend any money out of our HSA accounts for our day-to-day healthcare needs. We pay out of pocket for now to let the money compound for later years.
But what if that later never comes? I mean what if you end up not needing as much healthcare and have a large balance that you will not use?
Remember all those expenses you paid out of pocket over the years? You can claim all of them whenever you want. There is no time limit of how old those expenses must be. I maintain a digital folder where we dump all our receipts in. If we never end up using the money in this account, we will use these receipts to get reimbursed for expenses of years and decades past.
But what if you die with leftover money in your HSA? The money then goes to the named beneficiary of the account. If there is no beneficiary, the money then goes to your estate. But it is treated differently depending upon who that named beneficiary is.
If that beneficiary is your spouse: If you name your spouse as the beneficiary, it becomes their account and the same set of rules apply. The money in the account must be used for qualified medical expenses. If it is used for anything other than that, withdrawals become fully taxable at the spouse’s income tax rate.
Moreover, if the money is withdrawn or spent on non-qualified medical expenses by the surviving spouse before they turn 65, there is an additional 20 percent penalty on top of the taxes due. There is no such penalty after age 65 though but taxes will still be due if the money is spent on non-qualified healthcare expenses.
If that beneficiary is someone other than the spouse: The account closes on the day of your death if you name a non-spouse as the beneficiary. The value of that account then becomes taxable income for the beneficiary in the year of your passing.
And since taxes must be paid as if it is income for the non-spouse beneficiary, the stipulation to spend that money only on qualified medical expenses go away. And there is no 20 percent penalty for withdrawals before age 65.
The non-spouse beneficiary can be a person or an entity like an estate or a trust.
The non-spouse beneficiary can lower their taxes if they use the HSA funds to pay the original account owner’s medical expenses. Only expenses incurred within a year of the HSA owner’s death qualify though.
So, keep an eye out for this the next time open enrollment rolls around and jump all in.
Thank you for your time.
Cover image credit – David Peterson, Pexels