The debate over the constitutionality of the massive health care legislation enacted in 2010 continues. It’s not certain if most of the provisions will kick in as scheduled ... or ever.
Strategy: Take a second look at Health Savings Accounts (HSAs). They may be a tax-smart way for you to handle your medical expenses.
Although HSAs were initially slow to catch on, interest has been heating up. Recent tax law changes have generally improved HSAs.
Here’s the whole story: An HSA is like an Individual Retirement Account (IRA) for medical expenses. Contributions made by eligible individuals can be deducted above-the-line on Form 1040, or your company can make tax-deductible contributions on behalf of its employees—or both.
As with an IRA, there’s no current income tax on the earnings within the account. Furthermore, distributions are completely tax-free if the funds are used to pay for qualified medical expenses. Other distributions are taxed and they are also hit with a 20% penalty if they are taken before reaching Medicare eligibility age (currently 65).
HSAs are available to anyone who is not yet eligible for Medicare (i.e., someone who is under age 65), participates in a high-deductible plan and does not receive coverage under another health insurance plan. For 2012, a “high-deductible plan” is defined as a plan with a deductible of at least $1,200 and an out-of-pocket maximum of $6,050 for individual coverage; a deductible of at least $2,400 and an out-of-pocket maximum of $12,100 for family coverage. These limits are indexed for inflation. (IRS Revenue Procedure 2011-32)
Key point: Previously, the maximum deductible contribution was limited to the lesser of the amount of the annual health insurance deductible or an indexed dollar amount. But a 2006 law eliminated the deduction limit based on the health plan deductible. Instead, only the higher dollar threshold applies. Also, the 2006 law also authorized tax-free rollovers to an HSA (see below).
For 2012, the HSA contribution thresholds are $3,100 for individuals; $6,250 for family coverage. In addition, a “catch-up contribution” of $1,000 is permitted for individuals age 55 or older (see box below for the limits for the last five years).
Finally, be aware that any amount left over in your account at the end of the year may be used to pay medical expenses in the future. This provides a distinct edge for HSAs over flexible spending accounts (FSAs) for health care expenses. Reason: Unused FSA amounts are forfeited when the year ends. (A 2½-month grace period may apply.)
Tip: Under the 2010 health care law, the penalty for making HSA withdrawals for nonmedical reasons was increased from 10% to 20%, beginning in 2011. And drugs and medications other than insulin count as medical expenses only if prescribed.
A once-in-a-lifetime chance
Normally, you have to tax at high ordinary income rates when you take a distribution from an IRA.
Strategy: Roll over funds from an IRA to an HSA. A one-time rollover is exempt from income tax as well as the 10% penalty tax if you’re under age 59½.
This method of funding an HSA is particularly beneficial for someone who is nearing retirement or has already retired. The maximum amount that may be rolled over is limited to the maximum HSA contribution allowed for the year.
Tip: A tax-free rollover is only allowed once in your lifetime. The election is irrevocable.
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