Health Savings Accounts

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003 created health savings accounts (HSAs). Although the accounts may be used to pay for health costs prior to an account holder's retirement, the accounts also combine elements of traditional and Roth IRAs, thereby providing a more attractive tax incentive for retirement savings than either type alone.

Accounts can be established only by individuals who have high-deductible health insurance policies and no other form of health insurance (including Medicare). Participants can then make contributions to an account up to the amount of the deductible (or an amount set in law, if lower) and exclude those contributions from their taxable income. Those near retirement may also make larger "catch-up" contributions. There are no income thresholds imposed on the ability to claim a tax deduction for such contributions, and employer contributions (which avoid all income and payroll taxes) are also allowed.

Virtually any qualified medical expense can be reimbursed out of an account balance without incurring tax. Unused amounts can be carried over to subsequent years with earnings accruing tax-free. Before the account holder reaches age 65, withdrawals not used to reimburse qualified medical expenses are fully taxable and also incur a 10 percent penalty tax—treatment similar to that of an early withdrawal from a traditional IRA. While Medicare enrollees may not contribute to the account, they may use or bequeath any account balances they have built up.⁽¹⁾