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Personal Finance FAQ

Don’t Pay an Arm and a Leg to Keep Your Arm and Leg

This is part of a series. If you have not read the articles that build up to this one, I recommend that you do so first.

“Sound mind in a sound body.”

“Healthy, wealthy, and wise.”

“The greatest wealth is health.”

The quotations about health go on and on. We know that we need health insurance, and we frequently pay a lot for it, but often, we don’t really understand what goes into our health insurance policies. We show up at the doctor, provide our insurance cards, and hope that we don’t have to hock a kidney to pay for the services. Medical costs can be very expensive, particularly if we’re uninsured, and still quite painful even if we are insured.

This lesson will deal with what you need to know about your health insurance policy, whether it’s provided by your employer or you have to buy it yourself.

First, we need to cover why health insurance is important for you and your family to have. If you are independently wealthy and could cover healthcare in the event of a catastrophic health event for each member of your family, such as long term cancer care or transplants, then you don’t need health insurance. However, for the rest of us, it’s important to have some sort of coverage, mainly for the cases of catastrophic protection.

The primary purpose of any type of insurance is to protect you from a catastrophic loss. You have homeowner’s insurance to protect you in case the house burns down. You keep auto liability insurance to protect you in the event that you’re at fault in an auto accident which causes severe harm. You keep life insurance in case you die early and your family needs to replace your income or your other work. The same is true for health insurance. The idea behind health insurance isn’t so that you only have to pay a few bucks for a physical. It’s to protect you in case you get really sick or injured and have a very high medical bill.

The components of your health insurance policy

It’s important, no matter who provides it for you, that you know some of the basic components of your health insurance policy. Knowing what is covered and what is not covered will help you to prepare in case you do have health issues which arise.

Health Insurance Deductible

This is the amount of money that you have to pay before your insurance will cover the medical costs. This can be an amount per person or it can be an amount for the entire family.

Copayment

This is the amount which you have to pay for each visit or procedure. Some policies will count your copayments towards the deductible while some will require a separate deductible payment. Furthermore, some policies require a copayment after the deductible is met. So, for example, if you have a policy which requires a $500 deductible and then 20% copayment, and you have to go to get a minor operation which costs $2,000, your bill could be $800: $500 plus 20% of $1,500.

Both deductibles and copayments are reset annually, meaning that you have to make copayments and deductible payments each year, regardless of whether or not you hit the cap the previous year.

Payout limits

This is the maximum amount of medical coverage the health insurance policy will pay out over the life of the policy or during a given year. Because of the Affordable Care Act, newer policies do not have a lifetime payout maximum, but older policies will still have that limitation – usually $1 million. Depending on when you had your insurance policy issued, you may see annual payout limits as well. Newer policies may have limits between $750,000 and $2 million in annual payment limitations; these limitations went away in 2014.

Some plans can still put limits on the spending for health services which are not considered essential. Essential health care, as defined by the U.S. Department of Health and Human Services, includes:[1]

“items and services within at least the following 10 categories: ambulatory patient services; emergency services; hospitalization; maternity and newborn care; mental health and substance use disorder services, including behavioral health treatment; prescription drugs; rehabilitative and habilitative services and devices; laboratory services; preventive and wellness services and chronic disease management; and pediatric services, including oral and vision care.”

If you purchased your own healthcare policy for you or your family before March 23, 2010, you may still see payout limits, as these policies are not subjected to the reduction of limitations of the Affordable Healthcare Act.

Renewability

This is a clause which you must have in your healthcare coverage. It means that, as long as you continue to pay your premiums, you cannot be denied coverage in the future. This doesn’t mean that the insurer won’t raise your rates; however, you’ll still have insurance. If you want to retain the same rates, you’ll need to have a non-cancelable healthcare plan.

Pre-existing condition coverage

Often referred to as a “waiting period,” this is how long an insurer will wait before beginning to cover you for a pre-existing condition. If you have asthma (like I do), then, depending on your policy, your insurer may not cover you for between three months to one year. If you have a pre-existing condition, come clean with it. Don’t try to hide your condition hoping that it doesn’t get picked up. Insurers can void your policy if you fraudulently hide information or mislead them on your insurance application. Note that Affordable Care Act (otherwise known as Obamacare) policies do not allow you to be disqualified for a preexisting condition.

Managed care plans

A health insurance plan generally falls into one of three categories of care:

  • HMO (health maintenance organization): this is an arrangement where a group of medical care providers will provide your health care, with a few exceptions, such as having emergency treatment or needing treatment when you’re far away from home. Unless you meet one of the specified conditions, you won’t be covered if you seek coverage outside of your HMO. You will have a primary care physician (PCP) who will then determine your need for specialized care.
  • PPO (preferred provider organization): this is a similar arrangement to a HMO, except for a few distinctions. First, you can choose whomever you want to provide you care, but you’ll get the best discounts and deals if you stay within the PPO organization. Secondly, you’ll need to fill out more paperwork to get reimbursed for your medical expenses.
  • POS (point of service): this is like a blend of a HMO and a PPO. If you stay within the network, then you usually pay no deductible and a small copayment; if you go outside of the network, you are covered, but you will have deductibles and higher copayments.

Paying for your health care

Alas, for most people, the answer about how to pay for your health care is to grin and bear it. Some people think that they can deduct their health expenses from their taxes, but very few of them actually will be able to do so. The reason for this inability to deduct your expenses is that you must pay more than 7.5% of your adjusted gross income (AGI) in medical costs (which can include your insurance premiums if you have to pay them with after-tax dollars), and only then, it’s whatever you paid above 7.5% which is deductible. IRS Publication 502[2] has everything you want to know about deducting medical expenses.

So, you’re left with the choice of self-insuring – paying for healthcare expenses as they arise or buying health insurance. I don’t recommend the self-insurance route unless you’re extremely wealthy. The point of health insurance, just like all other forms of insurance, is not to get the insurance to pay for every little scratch that happens, but, rather, to protect you from catastrophe.

In general, I like to choose health insurance policies which have the highest deductibles possible to get lower rates and then saving the money so that you have the available cash to pay for those deductibles. You want to choose, where possible, a plan that has the highest deductible and then no copayments afterwards. This will allow you to know the maximum amount, per year, that you would have to pay for medical coverage: your deductible plus your insurance premiums.

Then, you simply set aside money in a side account to pay for those premiums and for the deductible. If you can afford it, in a year when you don’t meet the deductible, divert the extra money into an investment or retirement account. If you can’t afford it, then continue to set aside money until you have enough in reasonably liquid assets to afford the total costs.

This approach, particularly if you don’t have many assets, does entail some risk, as you may get hit in the early years with medical expenses which would cause you to have to divert money from other goals to pay for the medical expenses. However, if you are reasonably healthy, then the lower premiums that you pay should make up for the higher deductibles which you usually won’t have to pay to save you more money overall.

The reasoning behind this approach, not only for what should be lower overall costs over time, is that you can use Monkey Brain’s own accounting against him. Monkey Brain doesn’t like the thought of being sick and not being able to get care, so when you create the side account for medical expenses, he’s not going to push too hard to shift some of that money around to buy new shoes or to buy a 183” flat screen TV. Then, once a year, all you have to do is make one decision to shift the excess money to retirement savings or to investments, and voila! You’re done. No fighting ego depletion,[3] and you’ve used mental accounting to your advantage.

Let’s see an example of how this works.

Say you have a family medical plan which costs you $750 per month. The maximum individual deductible is $1,000 and the maximum family deductible is $4,000. Beyond that, the insurance company pays all costs.

What is the highest total amount you could pay for medical care in a year?

It’s merely 12 X $750 + $4,000, which is $13,000. In order to set aside enough to pay for the total, divide $13,000 by 12. You would set aside $1,083.34 per month into the medical side account. When you have to pay for insurance or for a medical bill, you simply transfer the money over into your spending account and pay for it. At the end of the year, if you have any money left over, send that money into your retirement account or your investment account.

Isn’t forced savings a modern miracle?

The High Deductible Healthcare Plan (aka the HDHP)

Believe it or not, the government does have one tax-advantaged way for you to pay for your healthcare. It is called a high deductible healthcare plan (HDHP). A HDHP is just what its name implies – you pay a higher deductible than you would in a normal healthcare plan, and, in exchange, the insurance premiums are usually lower. Additionally, the government allows you to contribute to a health savings account (HSA) with pre-tax dollars. So, instead of having to earn $25 to get an after-tax amount of $20 to pay for that prescription, you only have to earn $20 to pay for that prescription.

To be qualified as a HDHP, the plan must have deductible limits within a certain range as defined each year by the IRS. For 2020, the limits are as follows:

 

  Minimum Maximum
Single (sometimes known as self-only) $1,400 $6,900
Family $2,800 $13,800

There is a limit to how much you can contribute to a HSA which is also determined annually by the IRS. In 2020, the limits are as follows:

  Maximum annual contribution
Single (self-only) $3,550
Family $7,100

If you are age 55 or older, you can contribute an additional $1,000. Once you sign up for Medicare (which should happen once you hit age 65), you cannot make further contributions to your HSA.

You can use the HSA to pay for qualified medical expenses. Qualified medical expenses are defined by IRS Publication 502;[4] you can also pay for prescription drugs and insulin.

HSAs also have additional benefits. When you begin paying for long-term care insurance (which we’ll discuss in a later lesson), you can pay for them with your HSA. Once you turn age 65, you can use the HSA monies for other uses. Keep in mind, though, that if you pay for qualified medical expenses, you can withdraw the money tax free; if you use the money for other expenses, you will pay ordinary income tax on your withdrawals. If you make an unqualified withdrawal (e.g. not for a qualified medical expense) before age 65, you will have to pay both ordinary income tax and a 20% penalty on the money that you withdraw.

Therefore, the HSA serves both as a tax-free way to pay for qualified medical expenses and it can serve as an additional retirement account. Double win!

The use of a HDHP if you are healthy

The most common complaint about most insurance plans is that they use the healthy to subsidize the unhealthy. If you rarely go to the doctor, you’re going to pay in premiums to pay for the people who go to the doctor quite a bit.

With a HDHP, if you never have to go the doctor, then you’ll get to save up money in your HSA and let that money grow either tax deferred (for non-medical expenses in the future) or tax-free (for medical expenses in the future).

The use of a HDHP if you’re chronically ill

It seems counterintuitive to think that a HDHP would be useful if you’re chronically ill. However, in many cases, your out of pocket payments for treatment and prescriptions in a traditional insurance plan will cost much more than the deductible you’d pay in a HDHP, and you may wind up saving money in the long run.

This is particularly true if you have an insurance plan which requires significant co-pays, especially after the deductible was met.

You’ll need to look at your total medical expenses – insurance payments, deductibles, and out of pocket medical expenses – and compare them to what you’d pay with a HDHP – insurance payments and deductibles – to see if it makes sense to convert to a HDHP.

Other Healthcare Plans

Flexible Spending Account (FSA)

A flexible spending account is similar to a HSA in that you set aside pre-tax dollars to put into the FSA for spending on qualified medical expenses. The biggest difference is that with a FSA, it’s use it or lose it, meaning that, if you have not spent the money by the end of the year, you forfeit that amount, save $500, which can carry over into the next year. There is also a $2,750 contribution cap per employer, meaning that if you work two jobs which have FSAs, you could contribute $5,500 to your FSA. If you have a HSA as well, then your FSA can only be used for dental and vision expenses.

Health Reimbursement Arrangement (HRA)

If you’re a small business owner, then a HRA is an alternative to paying for standard healthcare plans for your employees. HRAs work in a similar manner to FSAs except that the employer funds the HRA completely (instead of having it withdrawn from salary like a FSA) and the funds can roll over from year to year. Furthermore, HRA funds can be used to meet insurance premiums, deductibles, and copayments, as well as qualified medical expenses. It is possible for an employee in a HRA to have no out of pocket medical expenses.

It’s important that you have appropriate and adequate healthcare coverage. I’m a fan, in general, of the HDHP / HSA arrangement if you can get it. Many people feel like they are locked in to certain employers because of the employer-provided healthcare. Having a HDHP with a HSA, particularly once you’ve funded it for a couple of years and have the money set aside to meet the deductibles can be a great way to create the flexibility and freedom you’re looking for, and, over time, the premiums of a HDHP will be lower.

No matter which way you go, though, it’s crucial to have health insurance.

As you get older, though, you’ll find that health insurance won’t cover an aspect of life which many of us face: long-term care. We’ll cover long-term care and long-term care insurance in the next article.

Related articles:

Sound mind, Sound Body, Sound Wallet: My Interview With Olympic Gold Medalist Wendy Boglioli

Preventive Medicine Costs Less Than Reactive Medicine

Monkey Brain is Bad for His Own Health

 

[1] https://www.healthcare.gov/fees/plans-that-count-as-coverage/

[2] http://www.irs.gov/publications/p502/index.html

[3] https://www.hullfinancialplanning.com/how-ego-depletion-allows-monkey-brain-to-buy-junk/

[4] http://www.irs.gov/publications/p502/ar02.html#en_US_2012_publink1000178885

The next article in this series is Long Term Care Insurance.

By

Jason Hull, CFP®, was the co-founder of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies. He also was the co-founder of open source search consultancy OpenSource Connections, a premier Solr and ElasticSearch firm. He and his wife FIREd (financial independence retire early) at 46 and 45, respectively. He has a BS from the United States Military Academy at West Point and a MBA from the University of Virginia Darden Graduate School of Business.

You can read more about him in the About Page.

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