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The Medicare-reform law passed at the end of 2003 created new, tax-favored health savings accounts (HSAs) for those too young for Medicare. They are new enough that many people have not heard of them, and they have not yet been tested by the courts and the IRS. However, they are an exciting addition to both financial and retirement planning and may prove to be of significant benefit to you.

Almost anyone not qualified for Medicare (under 65) who has a qualified, high-deductible health plan can participate in an HSA. However, if you are a dependent for another taxpayer, or are covered by more than one health care policy you would not be eligible.

A qualified high-deductible health policy is one with a deductible of at least $2,300 per family or $1,150 for individuals. There are limitations on the out-of-pocket expenses – in 2008 they could not exceed $11,600 for a family or $5,800 for an individual.

Annually you can contribute the amount of the deductible that is charged before any benefits kick in. The limitations for 2009 are $3,000 for individuals and $5,950 for families. If you are over age 55 you can contribute an additional $500 per year.

This is a great way to either pay the majority of your medical expenses tax-free (as opposed to the 7½% AGI requirements for itemizing medical expenses) or to save extra tax-deferred money for retirement and the increased medical expenses we all face as we age. You can deduct your HSA contributions regardless of whether you use itemized or standard deductions and regardless of your income. Your earnings on the account grow tax-deferred and are tax-free at distributions, but only if used for qualified medical expenses. Like an IRA, if you withdrawal the money for unqualified reasons you face full taxation plus a 10% penalty. After age 65, the account acts like an IRA – you can withdraw money without a penalty and the funds are taxed at your applicable marginal tax bracket.

To invest in an HSA, you first need to purchase a high-deductible health insurance policy that carries the qualifications listed above. Second, you need to search for an appropriate HSA. Some companies like Blue Shield and Assurant (formerly Fortis) can offer both, but you need to carefully think over your investment options and the expenses within the account, and any limitations to coverage. You can also set up an HSA separately. eHealthInsurance.com is one place to begin searching for an account. Your investment options ranges from variable and fixed interest rates to some mutual funds. As HSAs become more popular investment choices, investment options should become more numerous.

An example of an HSA in action: A 37 year old sole proprietor with a $1,200 a year policy and a $2,000 deductible can write off $3,200 a year (the premiums for a small business are now 100% deductible and the $2,000 goes into an HAS.) If this account is not used for medical reasons by age 65, and the investments earn 8% after expenses, the business owner will have an additional $190,000 towards their retirement. If they do have any medical expenses, the expenses will be paid with tax-free money. Either way, if you have the additional money to save, this is a great opportunity for lowering your tax bill and protecting your future. Please be aware that the tax savings on HSA's is at the federal level and California does have different tax rules regarding the earnings in an HSA that currently are not in the taxpayers favor.

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Health Savings Accounts: What They Are and How They Work.

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