An HSA: The Right Rx for You?

Here's how to tell if a health savings account makes sense. Be warned, it's unlikely to cover your post-retirement medical bills

By Ellen Hoffman

Paying for post-retirement health care is only going to get tougher for the millions of Americans who plan on leaving the workforce in the next 20 years. Medical costs will continue to soar while the number of companies offering health benefits to retirees will decline -- a consideration for anyone who wants to stop working before they're eligible for Medicare. And once people can get Medicare, they'll still be faced with expenses for Medicare premiums, deductibles, prescriptions, and a Medigap policy.

The new health savings account (HSA), a sort of 401(k) for medical expenses enacted as part of last year's Medicare legislation, has been promoted as at least a partial solution. But the rules governing these accounts are complicated, and the potential payoff may not be as great as you would think. Here's a guide to help you understand these new savings vehicles and whether they make sense for you.

EMPLOYER CONTRIBUTIONS?

  You must be under the age of 65 to open an HSA, which requires a trustee such as a bank or a brokerage firm. But before you can actually open the HSA, you'll need what the government calls a high-deductible health plan (HDHP), a health-insurance policy with a deductible of at least $1,000 for an individual and $2,000 for a family. Each year you may contribute tax-free savings into the HSA up to the amount of your policy's deductible, with a cap of $2,600 for an individual and $5,100 for a family. You also get a tax deduction for the amount of the contribution.

If your employer offers the HDHP-HSA combination as a health-insurance option, it might also contribute to your account as part of your benefits package. A March survey of employers with 500 or more employees by Mercer Human Resources Consulting found that most plan to offer an HSA, but not until 2005 or even 2006. Some 60% of companies that plan to offer an HSA think they may contribute.

The money contributed to an HSA -- whether by you or your employer -- accumulates tax-free, and you may withdraw it tax-free before the age of 65 for "qualified" medical expenses. The money you don't spend remains invested. People under 65 who withdraw money from the HSA for purposes other than qualified medical expenses must pay income tax and a 10% penalty on the withdrawal. (For more information on qualified medical expenses, go to the IRS's Web site.)

NOT ENOUGH.

  Once you're 65, you can take the money out, pay income tax on it, and spend it -- without penalty -- on anything you want. For details, see the U.S. Treasury Dept.'s Web site.

The potential tax savings from an HSA may be attractive to anyone who wants or needs to shelter income. But chances are an HSA won't go a long way to covering your medical expenses in retirement. The Employee Benefit Research Institute (EBRI), a nonprofit research organization based in Washington, D.C., has released an analysis showing that a 45-year-old who starts an HSA now, has a $1,000-deductible policy, and contributes to the account for 20 years, would have $47,000 in the account when he retires at 65, assuming 5% annual returns and spending only 10% of the amount in the account on medical expenses.

EBRI researcher Paul Fronstin, who authored the report along with EBRI President Dallas Salisbury, says that amount doesn't compare favorably with a conservative estimate of $150,000 the retiree would need for medical expenses if he lived only to age 80, which is below his average life expectancy (81 for a man, 84 for a woman).

ONE-STOP SHOPPING.

  If an HSA still sounds like an appealing option for you, don't rush to sign up for a high-deductible plan -- especially if your employer is paying the bulk of your health-insurance costs -- warns Ed Kaplan of Segal Co., New York-based employee-benefits consultants. If your choose to go the HSA/HDHP route, you could sacrifice health coverage that meets your current needs in exchange for putting aside a little bit of money. And Ray Herschman, Mercer's national practice leader for consumer-driven health care, points out that employers will probably make it difficult or expensive for you to give up the HSA/HDHP and return to your original policy.

If your employer doesn't offer an HSA or if you're self-employed, you can get free-standing HDHP coverage and open an HSA account. To search for free-standing options, visit hsainsider.com, where the column on the left side has links to insurers and trustees that will hold the accounts. At eHealthInsurance.com you can also search by clicking on "medical" under "available plans," on the left side. These plans, while less costly than traditional health-insurance plans, aren't cheap: A 49-year-old man can expect to pay anywhere from $100 to $400 a month for an HDHP.

An important issue is whether you want to get both your HSA and HDHP from one provider or separate ones. Your choice of the HSA account should include consideration of the investment options offered by the trustees. Many trustees are banks, which put the contributions in low-earning vehicles such as money markets. Some companies, including Assurant (AIZ ) and The Principal (PFG ), are setting up "one-stop shopping" options that will offer both the insurance and the account, but these aren't available yet. They say this approach will minimize paperwork and allow them to offer a wide range of investment options, including mutual funds.

HEDGING STRATEGY.

  Also, check the fees. Some current offerings, in addition to administrative costs for the health insurance, require a bundle of charges for the HSA -- for setup, applying, monthly or annual administrative costs, and in some cases, another fee if you don't maintain a minimum balance.

Phil Cook, a financial planner in Torrance, Calif., suggests comparing the costs and the coverage of your current policy with the HDHP policy you would buy. People most likely to benefit from an HSA are those whose current health-care expenses are low or who are in a high tax bracket. Cook, who plans to open an HSA for himself and his wife, points out that you can maximize growth in the account by paying routine medical expenses from sources outside the HSA.

Not tapping the HSA on a regular basis can also provide a hedge against having to withdraw money -- and sell investments -- at times when the market and the value of your HSA account are low. However, when you add up the costs of insurance premiums, HSA contribution, and out-of-pocket expenses, this strategy could amount to a lot of cash outflow.

OTHER OPTIONS FIRST.

  Dan Perrin, executive director of a coalition that fought for the HSA legislation and the publisher of the HSA Insider Web site, offers these tips if you decide to shop for an HSA with the goal of stockpiling money for retirement medical expenses: Maximize your savings by getting as high an insurance deductible as possible to allow for higher contributions, get insurance that pays 100% of the costs after the deductible, and avoid policies with a per-person deductible.

Bottom line: If you've maxed out on all of your other retirement-savings options -- IRA, Roth IRA, and 401(k) -- and you don't spend a lot on health care now, an HSA might make sense for you. But chances are that you'll supplement your HSA money with other funds to pay for your health care in retirement, rather than the other way around.

In addition to writing Your Retirement for BusinessWeek Online, Hoffman is the author of The Retirement Catch-Up Guide and Bankroll Your Future Retirement with Help from Uncle Sam. You can contact her through her Web site, www.retirementcatchup.com

Edited by Patricia O'Connell