It’s open season again. Every year around this time I get questions from people about whether they should sign up for a High Deductible Health Plan (HDHP) and save in a Health Savings Account (HSA). Like almost all personal finance questions, the answer to it is, “It depends.”
Since it’s normally impossible for me to consider all of your unique factors to help me answer, I decided to create this tool to help you make your own decision.
While there are plenty of tools out there from insurance companies to assist your plan selection, I haven’t encountered one that combines all the potential costs and benefits together in one dollar amount. So, that’s what I did with my HDHP + HSA Decision Tool.
As you will see from the tool, the reason that this decision is not as straight forward as some others is because there are two levels of economic benefit or loss. One is in the current year, and the other for all the years down the line. It’s an easy decision if using HDHP + HSA lowers your costs now and helps you save later. It’s not as clear-cut if only one of those two conditions is true.
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Why HDHP + HSA?
Like all insurance, the higher the deductible you have on your health insurance, the lower your monthly premium. This is because you self-insure a greater amount, which means lower risk and cost for the insurance company.
So who would benefit the most from HDHP? Obviously the answer is those who can self-insure a greater amount, or those who are healthy and have little need for medical care. However, most people were used to having low deductible coverage, and habits are hard to break. To further sweeten the deal, the government created HSA to encourage people to take on more healthcare cost, which can be offset partially by tax incentives.
HSA is the only tax-advantaged account that provides triple tax breaks. For participants in employer’s cafeteria plans, contribution to HSA is free from payroll tax and income tax in the year it is made. Once the money is in the HSA, any unused amount grows and is distributed tax free for qualified medical expenses. That’s a portion of your income that will never be taxed!
The caveat is that if you do distribute it before age 65 for non-qualifying expenses, you will pay an additional penalty plus income tax. After age 65, you will only pay income tax, like distributions from your pre-tax 401(k) or IRA.
Is HDHP + HSA right for you?
So if you rarely go to the doctor, and have exhausted all of your tax-advantaged saving opportunities, such as 401(k) and Roth IRA, using a HDHP so you have access to HSA is a no brainer. For most people who do use medical care to a certain degree, the problem becomes knowing how much more it might cost you under HDHP, how much tax savings you get to offset the extra cost, and whether the future tax savings is worth it.
#1: Consider the amount of HSA contribution
Before we calculate the change in healthcare costs, let’s set up some basic parameters. The maximum HSA contribution in 2017 is $3,400 for an individual or $6,750 for a family. This includes both your contribution and the free employer contribution. Of course, you can choose to contribute less at a level that fits your budget.
Note that while you get tax savings from a HSA contribution, the actual level varies by your income level. For example, if your salary is much higher than the social security income limit ($127,200 in 2017), then you likely won’t get any social security tax savings from being able to exclude contributions from income. On the other hand, you are likely to get a higher income tax saving amount because you may be at a higher income tax bracket. Therefore you need to enter your income and the highest marginal income tax rate correctly.
#2: Estimate current year benefit / loss
Your annual healthcare costs include your insurance premium and the actual out-of-pocket costs. As a rule of thumb, the more you use healthcare, the more expensive it may be under HDHP. However, HDHP usually has lower premiums. (Although according to my observation in the last few years, the premium difference between HDHP and a low deductible plans is getting smaller.)
While you may have a good idea what your medical costs would be under a low deductible plan, it might be difficult for you to imagine how much it costs to pay the full cost up front until you meet your deductible. (For example, you may be paying a full $300 physician fee for a routine specialist visit versus a $30 copay.) You might want to use calculators such as this to help you estimate out-of-pocket costs. Your employer’s insurance provider may also have a version of a calculator.
If before any tax savings, your healthcare cost is similar under both plans, then it’s likely you will save some money using HDHP. For most moderate healthcare users, the low deductible plan may cost less upfront. However, HDHP may come with higher tax and company incentives.
To illustrate the overall economic benefit, I apply both the tax and employer incentives to lower your total healthcare cost. Of course in practice, all of your money is in one pile and you don’t have to use tax savings to pay for medical care. You might notice that in your specific case, the overall out-of-pocket cost under HDHP becomes lower after the HSA tax deductions.
Note that low deductible plans also come with tax savings. No matter which plan you choose, the premium you pay is payroll and income tax free if you are under a cafeteria plan. The tax savings may be higher from a low deductible plan if you don’t put enough in HSA, because the premium for a low deductible plan is usually higher.
#3: Project future benefits from tax savings
Lastly, we will take a look at the future savings. You are able to use your HSA balance in your current year like you do with your FSA. However, some may choose to pay out of a checking account and let the HSA balance grow because the distribution may be tax-free in the future. In the end, it’s up to you to decide whether to save this particular amount for medical costs, retirement, or a yacht.
So let’s start with the fact that you are able to save a particular amount (under the HSA contribution limit). In my example it’s $3,000 a year. You just need to decide which account you want to save it in. The baseline will be in a taxable brokerage account, because if you choose a low deductible plan, you can’t use a HSA.
While taxable accounts may have a lower after-tax return, the real tax savings you get from any single year’s contribution may not be as high as you imagine. This is because the tax rate on long-term investments can be much lower than on earned income. Here I assume the tax rate on long-term investments at an average of 15%. This may change depending on your other income level.
Depending on your income level, HSA contribution, and healthcare usage, you may find that HDHP and HSA costs or saves you from a few bucks to a few thousand dollars in the current year.
In this particular example, if you use this HSA balance in 30 years for a medical expense, you will get $843 savings in taxes in today’s dollar. However, if you end up distributing it for any other reason after you turn 65, you will actually suffer a slight loss compared to simply investing in a taxable account now.
To summarize, you will find that in this particular example, there is absolutely a benefit to use HDHP + HSA. Assuming you will definitely use the HSA balance for medical expenses in the future, your current total economic benefit is over $1,200 in today’s dollar!
However, if you don’t use the HSA balance for medical expenses at all, your current year saving doesn’t cover your future loss. This is because I assume the future marginal tax rate is the same as current rate in this example. You will notice that if you lower the future tax rate assumption, your current year benefit will become greater than future loss. So even if you don’t plan to use the saving on medical expenses after age 65, you still come out ahead.
What kind of situation are you in?
As humans, we naturally place higher value on the short-term loss over future gain. Using this tool, you may find that choosing HDHP results in extra cost in the current year, but having access to HSA saves you more in the long-term. This may be especially true if you expect high healthcare costs in the future. This is one reason you hear a lot of financial professionals honing the benefits of HSA.
Nevertheless, you may also find that after calculations, your current and future benefits add up to a negligible amount. If you are easily overwhelmed by complicated financial situations, maybe instead of adding another financial account, keeping it simple is best for you.
Or you may discover a low deductible plan is cheaper for you now, but you are still tempted by the future tax benefit. Have you maxed out all of your other tax advantaged accounts like 401(k) or Roth IRA? If not, increase your contributions there and you can also gain long-term tax benefits without the added complexity of HSA.
I hope this HDHP + HSA Decision Tool illustrates that choosing a healthcare plan is actually not a one size fits all decision. While a single year loss or benefit is usually not huge, over the course of your career they definitely add up. In addition, your need for healthcare also changes from time to time. It’s advisable to revisit this decision every year.
This tool also only applies to those who are part of their employer’s health plan. If you are in charge of purchasing your own insurance, or if you are self-employed, the calculation of cost and benefit may be more complicated.
Lastly, if you are filing jointly, and each of you own an account, make sure you coordinate the plan selections and HSA contributions. You should use this tool individually and then combine the results. For high earners, you may also have to consider the saving from avoiding additional Medicare tax.
Is this helpful? Let me know in the comment section below!