I had a client ask a great question this month: Should they contribute to a health savings account (HSA) or a Roth IRA? This is a great question, though unfortunately not one with an easy answer, because while both alternatives are good, each has weaknesses compared to the other in certain situations.
Roth IRA - Overview
A Roth IRA allows tax-free growth for your investments, has no minimum required distributions during your lifetime, and allows tax & penalty-free access to your contributions at any time (and to your earnings penalty-free after age 59 1/2, and tax-free also after 59 1/2 assuming you’ve had a Roth open for at least 5 tax years).
Health Savings Account - Overview
A Health Savings Account also allows tax-free growth but reduces your taxable income by the amount of your contributions (like a traditional IRA) and qualified distributions for covered costs come out tax-free (like a Roth IRA). On first glance, an HSA combines the best features of both Roth and Traditional IRAs and would thus seem to be the clear winner. However, let’s look a little deeper.
Is That an HSA or an FSA?
First, because most of us are less familiar with HSAs, let’s make sure we understand what these are. They are sometimes confused with a “flexible spending account” (FSA) which employers often sponsor and which allow you to set aside pre-tax dollars to pay for medical expenses (separate FSA’s for other types of expenses may also be offered; the most common other FSA is for dependent care costs). If your employer offers a flexible spending account, you can set aside as much as the plan allows (there is no IRS cap, but for various reasons the employers typically set maximum contributions) with the requirement that you must withdraw the funds for qualified expenses within a short period (the plan year plus a short grace period) or forfeit them (i.e., “use it or lose it”).
In contrast to an FSA, a health savings account is not a “use it or lose it” plan, and indeed, some of their popularity arises from situations where you don’t intend to use the money in the near term. With HSA’s the IRS does set annual maximum contributions, and the plan can be funded with employer or personal contributions.
HSAs Must Be Paired with an HDHP
However, to contribute to an HSA you must be covered by a “high-deductible health plan” (HDHP). From a public policy standpoint, these are intended to reduce health care utilization by more closely connecting dollars that “cost you something” with your health care choices. For that reason, while you may want to do some analysis and consideration of your specific situation, we can surmise that as a general rule people who tend to consume a lot of health care – because of chronic conditions or general life situation - are not the top candidates for a HDHP.
But if you and your family tend to be pretty healthy and low “consumers” of health care, a HDHP paired with an HSA can be economically beneficial not only in the near-term, but especially in the long run.
What are the requirements to be an HSA-qualified high deductible health plan?
- All covered benefits (except preventive care) apply to the deductible, including prescription drugs.
- Preventive services are not subject to deductible (the plan can require apply copayments to preventive care services.)
- For family plans, one deductible and out-of-pocket maximum apply – the entire family deductible must be met before benefits are paid.
- New deductibles apply at the beginning of each benefit year. Fourth quarter deductible carryover (a frequent policy in traditional health insurance plans) does not apply.
- The out-of-pocket maximum includes deductible (the dollars you pay before the plan starts paying benefits), coinsurance (example: your “percentage” share of expenses even after the plan is paying benefits), and copayments (example: $15 per office visit).
If you have this kind of plan, you may establish an HSA or fund it for the current year. Key limits that apply to HDHPs and HSAs for 2010 are:
| Single Coverage | Family Coverage | |
| Minimum HDHP Deductible | $1,200 | $2,400 |
| Maximum HDHP Out-Of-Pocket | $5,950 | $11,900 |
| HSA Contribution Limit | $3,050 | $6,150 |
| Additional Annual Catch-Up Contribution if over age 55 | $1,000 | $2,000 with a second HSA |
The Winner? It Depends…
Now, with that background, let’s consider a few specific examples where one or the other of these plans may outshine the other. Your circumstances may differ to some extent, but the rationale used should help you evaluate the choice in your own situation.
If you have a high income (over about $166,000 in 2009 if you’re married): Winner: HSA, because you are likely to run into limits on your ability to contribute to a Roth. In contrast, there are no income limits which keep you from funding an HSA.
If you anticipate needing to actually access the money for health care needs in the near term: Winner: HSA. because you would be able to take advantage of the HSA’s “triple crown” of tax advantages: reduction of your taxable income (without needing to itemize deductions) for contributions, tax-free growth, and tax-free withdrawals.
Note that you can take distributions from your HSA not only for your own expenses, but also for those of your spouse and dependent children - even if they are not covered by an HDHP and thus would not be eligible for their own HSA. Also note that you are not required to take medical expenses from your HSA. For a number of reasons, you might choose to let your HSA funds accumulate for the long term and cover your current medical expenses with other funds.
If you want to be able to withdraw the funds for non-medical purposes: Winner: Roth, because you can access the contributions without tax or penalty at any time, and the earnings after age 59 1/2. Withdrawals from an HSA for non-medical purposes are always subject to tax, and to an additional 10% penalty before age 65.
If you can afford to leave the funds to accumulate until after age 65, and then spend them on medical care: Winner: HSA, because you get the tax-free growth and tax-free distributions in the long-term, plus the current tax savings for your contribution.
Do You Have to Choose?
Of course, we’ve been ignoring the limitation implicit in my client’s question: that you must choose between these two arrangements. If your cash flow (or resources currently sitting in after-tax accounts) would allow you to fund both of these plans for long-term purposes, and you otherwise qualify, that would be even better than choosing one or the other!
Further, even if you favor the HSA over a Roth, since the contribution limits for HSAs are lower than for Roth IRAs, you could fund the HSA first and then direct any additional available resources to the Roth.
Postscript: HSA Hints
Insurance companies sponsoring HDHPs are required to have a financial services firm partner where you can set up an HSA, but keep in mind that you are not required to use that vendor for your HSA. When evaluating providers, be sure to explore fees, earnings on the account balance, and method of requesting withdrawals.
If you may need to withdraw from the HSA in the near-term, you will be more concerned with stability of value than potential returns. However, once your HSA balance is over the annual deductible of your HDHP, and certainly once it’s over the out-of-pocket maximum, you should consider thinking of the surplus balance as long-term money. Many HSAs have relatively low balances and are expensive for the vendors to administer, so costs can be relatively high. One vendor to consider if you’re focused on long-term growth of your balance is Health Savings Administrators, which offers a wide selection of low-cost Vanguard funds as investments. As always, check the small print so you don’t have surprises!
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