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Utilizing Medical Savings Accounts (FSA, HSA)

Health is wealth! Medical care can be extremely complicated, resulting in highly educated and skilled individuals to deliver the care you need. And access to that education and skill comes with a big price tag.


Fortunately, there are a few breaks that the IRS allows to pay for medical care that help to avoid taxes on medical expenses, but this again comes with some complexity, and sometimes even risk.

For one, there is a tax deduction, but this applies to a very small minority, and young professionals make up almost none of this. So you can probably count out any tax deductions for medical costs.


But, there are a few tax advantaged accounts that are available to many individuals, especially those who get health coverage through their employer.


Picking a health insurance plan is hard; you have to estimate when you’re going to get sick or hurt throughout the year, and how much it’ll cost you. It is almost impossible to know this, and then you have to balance the cost of premiums, co-pays, deductibles, coinsurance and out of pocket maximums.


There is no easy way to figure this out, but once you have that policy narrowed down, you may have a medical spending / savings account that can be used in tandem to pay for any co-pays, deductibles or coinsurance. Here are the main three medical expense accounts that may be available to you:


Flexible Spending Arrangement (FSA)


An FSA is an employer-sponsored account, it can not be set up by an individual.


Flexible Spending Arrangement is the IRS term for the account, but your company may call it something else (like a healthcare reimbursement account). The way this works is at open enrollment, you elect to contribute a certain amount into the FSA over the year. The amount you commit will be taken out of each paycheck pro-rata, and the money is available for you to spend on qualified medical expenses.


The money is available immediately - you don’t have to wait for the account to build through your payroll deductions, you can spend the full amount right away.


The benefit of this account is that it converts any out of pocket medical expenses into pre-tax expenses if it goes through the FSA. Let’s say you’re in the 24% federal tax bracket, 5% state, and 7.65% payroll tax. You would need to be paid $790, which would result in $290 of taxes, to net $500 that you can spend on medical expenses.


Or, if you commit $500 to the FSA and use that for medical expenses, you just saved that $290 in taxes.


The biggest downside to an FSA is that it is a “use it or lose it” account. This is where the risk comes in. Keeping with the same example, if you committed the $500 but only spent $400 throughout the year, then the $100 is kept by the employer. But, it would cost you $230 in tax to get $400 to spend on medical expenses - in other words, utilizing the FSA cost you $100 (in forgone contributions) to save $230 of taxes. I’ll take that tradeoff any day. If you way overcommit to the FSA, then this is where you are giving up money.


What happens if you leave your employer before the end of the year? Typically, any money you didn’t spend stays with the employer, and any money you spent but didn’t yet contribute has no claw back.


And finally, there are some household items you could use to stock up on if you’re at risk of giving up the $100 in my example - things like sunscreen, bandages, eyeglasses, etc. The custodian of your FSA sets some of these rules, so go to their site to see eligible items, or contact your employer.


FSAs are employer plans that operate within the rules of the IRS, but your employer has some control over the guidelines of the plan, so make sure you read about your account to understand what happens after leaving your employer, if any money can be rolled over to the next year, and how long you have to spend the money.


Health Savings Account (HSA)


An HSA is not an employer-sponsored plan - individuals can utilize them. Although you don’t need an employer, an HSA can only be paired with an HSA-eligible High Deductible Health Plan (HDHP).


My qualitative observation is that due to the policy having a higher deductible, the IRS allows you to pair a more powerful savings account than an FSA to bring some tax relief to overcome that higher deductible.


An HSA has the same tax benefits as an FSA, but what makes it superior is the ability to carry forward and invest the balance in the account. This is not a “use it or lose it” account, or an account controlled by your employer. Once you or your employer put money into your account, it is yours. If you leave your employer, you take that account with you. This creates a lot of different options as to how you manage your HSA.


Not only do you forgo the risk of giving up money you didn't use with an HSA, but you don't have to guess how much you want to contribute to the HSA at open enrollment. You can change your contributions at any time during the year. You can even do it directly from your checking instead of payroll. This means you don't have immediate access to the money like an FSA - you have to fund the account before using the money.


If you have the cash flow, arguably the best strategy with an HSA is to not spend it (until retirement) - you would max it out every year and pay for any medical expenses out of your checking account. That way, the HSA essentially becomes a tax-free investment account, holding money that has never been, and will never be, taxed by the IRS (and most states).


Another option is to use your HSA to pay for medical expenses - such a crazy idea! You can do this with your HSA debit card, or pay out of pocket and reimburse yourself with the HSA. As long as the HSA was open at the time you had these medical expenses, you can reimburse yourself for them.


As an example, say you got surgery on January 2nd, 2022 which cost you $1k after insurance. You hadn’t contributed to your HSA yet this year, so you had to pay with your checking account.


But, over the last 8 months, you contributed $1k to your HSA. Now you can reimburse yourself for that expense, since the medical care occurred while you had an HSA available to you (even though it wasn’t funded yet).


An HSA is a really powerful account, but shouldn’t necessarily be the reason for choosing a HDHP. You have to consider the pros and cons of the health insurance options available to you, and then you can utilize an HSA if it is available to supplement your expenses.


Limited Purpose FSA (LPFSA)


Ugh c’mon. We really have to add more complexity for a #richpeopleproblem. Just kidding, sorta.


Medical care is really expensive and this account adds some extra tax-free money for medical expenses, but I think the people that really need this account probably don’t have the cash flow to utilize it.

And let me be clear - I’m not judging anybody that uses this account; I would use it if I had an employer that gave me access. But I’m not sure this was totally necessary for the common folk.


The reason this account was created is because you cannot use an HSA along with an FSA, unless of course it is a LIMITED PURPOSE FSA. Then you can use the HSA in tandem with a LPFSA.


A LPFSA is an employer-sponsored plan - this account operates exactly the same as an FSA, but the funds can only be used for limited purposes. Specifically, I’ve seen them allowed to be used on dental and vision expenses, and I’ve also seen the ability to use it on medical expenses after reaching your deductible. Again, this is determined by your employer, so find out how yours works through them.


If we’ve already determined that an HSA is superior to an FSA, why would we use a LPFSA instead of an HSA?


The answer is you wouldn’t. You would only use the LPFSA if you plan on maxing out your HSA and you still want tax-protected money available for (limited) healthcare costs. The common person is probably already struggling a bit to keep up with all the insurance premiums and maxing out their HSA, that they don’t even think of deferring even MORE money into an account that has risk of forfeiture (use it or lose it).


The major strategy here if possible, is to max out your HSA and still not touch it, but use the LPFSA for dental and vision costs, or medical costs after you’ve paid your deductible out of pocket (if allowed). This way, you can keep your HSA untouched, and transform it into a tax-free investment account as opposed to a medical expense account.


Final Thoughts


Medical care is expensive; and due to the way certain people use these accounts (as I’ve described above), there are limits as to how much can be contributed, and who is allowed to contribute (based on what coverage you have).


These accounts are a good supplement to pay for medical costs with tax-free dollars, but they don’t work as well as a solid health insurance policy that fits your medical needs.


Your health insurance decision should not be based solely on the savings account associated - the coverage can potentially save you a lot more money than the ability to contribute to an HSA.


Start by determining which policy makes the most sense for you and your family, then supplement the expenses by utilizing the appropriate and available account.