Recently, I was treated to one of life's unpleasant surprises - a letter from the service company managing my "retirement" plan, telling me that the cost of my health insurance premium next year would be more than double what I paid last year. Now, the premium wasn't exactly cheap to begin with, but this is ridiculous; and I don't need to be a rocket scientist to figure out that the cost of my health insurance is just going to keep getting worse, as we baby boomers start moving through the last stages of our lives.

Forget the long term political issue of how we're going to fund Medicare; this is a problem that affects me and it's going to affect you, as well. Using a Health Savings Account (HSA) to fund your medical expenses may not be the best approach for everyone - but, everyone should at least consider using one. The availability and cost of health care is always listed as the number one problem that small businesses have today. An HSA can be used by an individual operating as an independent contractor to cover personal health care needs, or by a small business to provide at least some health coverage for its employees. So, this will highlight how HSA's work and touch on an example of how the math might benefit you.

Health Savings Accounts are similar in many ways to 401k's and IRA's - they allow you to set aside funds on a tax deferred basis, have a few restrictions on how they can be used, and must be administered by an IRS approved trustee (usually a bank, insurance company, mutual fund, etc.). They must be used in combination with a High Deductible Health Plan (HDHP); generally speaking, the money you sock away in an HSA is first used to fund your medical expenses, with the HDHP kicking in to cover medical expenses above the high deductible threshold.

Here are some specifics. As mentioned above, you must first purchase an HDHP, with a minimum deductible of at least $1,050 ($2,100 for a family) and a maximum deductible of $5,250 ($10,500 for a family). The purpose, obviously, is to make certain that a safety valve is in place to cover extraordinary medical costs in any single year and you won't be able to open the HSA without one. Then you set up the HSA with a financial institution, basically the same way that you would open an IRA. In 2006 you can contribute the lesser of the amount of the deductible on your HDHP, or $2,700 for an individual, $5450 for a family; these amounts are tax deferred - you can deduct the contributions from taxable income on your return. So, here's the first benefit - the government is now paying a portion of your medical expenses.

You make withdrawals from the HSA to pay your medical expenses as you incur them. If those medical expenses exceed the deductible on your HDHP, it will then start picking up your medical expenses according to whatever provision you have in the policy. However, if you have funds left over in your HSA at the end of the year, they roll forward (remain in the account) and can be used in future years to cover medical expenses that you incur then. In other words, if your family had opened an HSA with $5,450 in year one and incurred only $3,000 in medical expenses during that year, $2,450 would remain in the account to be used in subsequent years (in addition to contributions in those years). This is the second benefit of an HSA - there is no "use it, or lose it" provision in these accounts; if you and your family are healthy, they provide a great means of building up a reserve against extraordinary medical expenses in the future. The third benefit of an HSA is that income earned in the account is also tax deferred again, just like an IRA.

Withdrawals from an HSA are not taxable, as long as they are used to cover medical expenses, but they cannot be used to pay the HDHP premium, unless you are unemployed. If withdrawals are used for non-medical purposes, they are not only taxed, you also have to pay a 10% penalty on the funds!

There are a few age issues that should affect your thinking on these accounts. You must be under 65 to make contributions to an HSA; if you're 65, or older, you are eligible for Medicare and cannot participate in an HSA. However, if your age is between 56 and 64, you can contribute an additional tax deferred "catch-up" amount of $700 in 2006 (going up incrementally to $1,000 in 2009) to the HSA. If you have an HSA when you turn 65, it converts to an IRA, but withdrawals are still not taxed, if they are used for medical expenses. Finally, some experts adhere to the idea that these accounts are not as good for older workers; one of the benefits of an HSA is to build up the account balance to use for future medical expenses as you get older and, obviously, the older you are when you start the account, the less time you have to accomplish that.

Small businesses can use HSA's to provide some basic medical coverage for their employees. The employee still has to get an HDHP to participate, but both employers and employees can contribute to the account on a tax deferred basis. With an HSA, if the employee leaves the company, he's entitled to take the account with him. The major downside of providing HSA's to employees, is probably that the company has no control over how employees actually use the money. If they decide to use the money to buy a new car, or go on a vacation, they will have to pay taxes and the penalty on the withdrawal, but the company has very limited legal recourse to stop them from doing it. If that's money that your business contributed, it's clearly not doing what was intended.

When you compare an HSA with traditional health insurance plans, the math will depend on individual circumstances, but it can be compelling for some people. Let's assume you're forty years old, paying $1,000 a month for health insurance and another $2,000 a year in deductibles and co-pays, for total annual after tax expenditures of $14,000. Alternatively, you purchase a $5,000 deductible HDHP for $500 a month, put $5,000 in an HSA, and incur $3,000 in out of pocket medical expenses. Here you've incurred total out of pocket medical expenses of $9,000 ($6,000 for the HDHP and $3,000 in other expenses), less the tax deduction on the $5,000 in the HSA. You also have $2,000 in tax deferred funds that is carried forward to use in future years.

The math obviously doesnt work this well in every case and each of us has to look at our own particular circumstances. The point here is not that HSA's are a great deal for everyone - they are not. If your medical expenses go up every year, shame on someone else, or shame on the system. But, if you throw money away, because you didn't "have the time" to investigate whether or not an HSA would have helped, shame on you!