The Do-It-Yourself Health Savings Account
When deciding how much to set aside for an emergency fund, there is a growing category of expenses most people tend to overlook: potential out-of-pocket health-care costs. Even if you haven’t opted for a high-deductible health-care plan, it’s likely that your out-of-pocket health-care costs have jumped up substantially in recent years. Not only have health-care premiums increased dramatically, but so have the co-payments and deductibles associated with many health-care plans.
The magnitude of those numbers and the sobering statistics about the extent to which health-care costs can derail household finances suggest that households should make sure that their emergency funds include an allowance for health-care expenses that their plans don’t cover.
This is the idea behind flexible-spending accounts, which enable you to set aside pre-tax dollars to pay for out-of-pocket costs not covered by your health-care plan. You can use an FSA to cover everything from co-payments to prescription expenses to health-care costs that your plan did not pick up. Yet FSAs have an important downside: If you don’t use the assets you’ve put in them, the money doesn’t roll over to the next year. Unless you’re able to anticipate your out-of-pocket costs with some level of precision (for example, you expect to be on a certain drug or see a certain specialist for the foreseeable future), the use-it-or-lose-it risks of putting too much money into an FSA outweigh the benefits.
On the other hand, health-care savings accounts do allow you to roll over your money from year to year. However, they’re only available to participants in high-deductible health-care plans, which have lower premiums and higher deductibles than traditional health plans.
Given these two types of accounts, a two-part health-savings program, consisting of FSA assets plus additional assets held outside the FSA, may be worth considering. Such a two-part plan would work as follows.
Part 1: Flexible Spending Account. Fund an FSA with an amount that you think, with some degree of certainty, you’ll be able to use on health-care expenses in the year ahead.
Part 2: Supplemental Health-Care Account. Create a separate pool of liquid assets to cover any additional out-of-pocket costs that arise once you’ve exhausted your FSA funds. How large should the supplemental health-care account be? Your company’s out-of-pocket maximum, less your FSA amount, may be a reasonable amount if you can swing it. Unlike FSAs and the health-savings accounts that can be used in conjunction with high-deductible health-care plans, you can’t put pre-tax money into your supplemental health-care account. However, the money in your supplemental account won’t have to be spent in a single year. If you spend only a fraction of your supplemental account in year 1, you’d just need to top it back up in year 2.
Those who aren’t already funding Roth IRAs could experiment with holding their health-savings account within a Roth. The pluses: You can withdraw your Roth IRA contributions at any time and for any reason without triggering taxes or a penalty, and if you don’t end up spending your contributions to cover health-care costs, you can withdraw the assets on a tax-free basis during retirement.
Finally, be sure to track your out-of-pocket expenses for health care. If these costs exceed 7.5% of your adjusted gross income, you can deduct the amount over 7.5%.
Contributions to a Roth IRA are not tax-deductible, but funds grow tax-free, and can be withdrawn tax free if assets are held for five years. A 10% federal tax penalty may apply for withdrawals prior to age 59 1/2. Please reach out to myself or Blair for more information on how it may apply to your particular situation.
