HDHP vs. conventional health plan: How to determine the best fit

If your client has a chronic illness, he or she may be an excellent candidate for an HDHP. It all depends on the tax bracket.

It is often suggested that those in good health should opt for a high-deductible health plan (HDHP). The logic behind the argument is as follows:

A high deductible health plan will save a healthy person money. This savings comes from:

The low insurance premiums: HDHP premiums are much lower than the premiums of conventional health insurance plans (insurance plans with conventional deductibles).

The absence of ongoing medical care: Since preventive care is included at no — or reduced — cost, there is considerable savings available with an HDHP.

It is a relatively simple formula:

Low Premiums + Free/Low Cost Preventive Care = Savings

The Bogleheads approach to high-cost healthcare: total return

This begs the question: If you’re unhealthy, should you opt for a conventional health plan? Not necessarily. Bogleheads makes the point­:

You are most likely to benefit from an HDHP if you are either in good health or have very high prescription drug costs.

Why? Because an HDHP effectively caps your liability for medical expenses. To illustrate, consider a fictitious example:

Themistocles is in poor health, with high ongoing medical expenses. Each year, Themistocles must pay medical expenses, including prescription drug costs, to the tune of $100,000. Themistocles can choose either an HDHP or a conventional “platinum” level plan. Irregardless of the plan selected, Themistocles will reach the out-of-pocket maximum.

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You can see in the chart above that the answer is clear: even though the HDHP has a higher deductible, the cost savings offered by the lower premiums more than makes up for the higher out-of-pocket maximum. For the individual undergoing high cost healthcare, the HDHP is the superior choice. Bogleheads is correct. In the example, Themistocles saves $458 by opting for the HDHP. Simply put:

Low Premiums + Capped Liability = Savings

But, this comparison ignores one important variable (and the topic of this article): Health Savings Accounts (HSAs) and the tax benefits available with their use.

Health Savings Accounts and tax deductions

Tax-deductible contributions are made to a Health Savings Account and are withdrawn tax-free to pay for qualified medical expenses. Going back to our example:

Themistocles is in poor health. As such, he contributes the maximum he can into his HSA account each year, $3,300. He does this because he knows that he will reach his HDHP's out-of-pocket maximum. Having made the contribution to the HSA, Themistocles now has a tax deduction.

See also: 11 health insurance tax facts you need to know

For those taking the Bogleheads approach to high-cost health care, the tax-deductible contribution changes the after-tax cost of selecting an HDHP by a function of the individual's tax bracket.

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For Themistocles, this means that the HDHP turns out to be an even better deal; instead of saving just $458, Themistocles is now looking at a post-tax savings of as much as $1,765.

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Granted, the tax-advantaged Bogleheads strategy is only useful for those who know ahead of time that they are going to incur high medical expenses. For those with high ongoing medical expenses, an HDHP becomes a better deal as their tax bracket climbs higher. 

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In short, if an unhealthy individual opts for an HDHP, hitting their deductible annually, the tax savings offered by an HSA — in combination with an HDHP's low premiums but capped liability — makes for significant savings.

Low Premiums + Capped Liability + Tax Deduction = Great Savings

Consider the matrix below for deliberation on opting for an HDHP.

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In the middle

Individuals with moderate ongoing medical expenses may be best served by electing a conventional plan. With an HDHP, the individual may pay many costs out-of-pocket without ever reaching the deductible (the point at which the HDHP begins paying benefits). Consider a second example:

Darius must see a chiropractor every month for a treatment costing $335 per visit ($4,020 annually), which Darius would have to pay out-of-pocket were he to elect an HDHP. (The chiropractor's treatment does not qualify as preventive). Though the expense of the chiropractor visits add up, the total out-of-pocket is not enough to get Darius to the top of his deductible.

Were Darius to elect a conventional health plan, he would only be liable for a $40 copay for each visit ($480 annually). However, Darius would be liable for higher monthly premiums, higher than those premiums charged by an HDHP.

With such a narrow margin between the sum of all out-of-pocket expenses and the HDHP’s deductible, the tax deduction offered by HSA contributions plays an important role in determining which health plan is the superior choice. When in a low (10%) tax bracket, the HDHP proves the inferior choice.

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In a higher tax bracket, an HDHP proves a wise move:

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However, if out-of-pocket expenses rise far above the amount that can be deducted for HSA contributions (i.e. $3,300 for individuals for 2014), then the conventional plan — with its high premiums but low co-pays — wins out. For the Darius example, assume that instead of $335 per visit, the chiropractor’s fee was $500 per visit.

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Takeaway

The matrix below summarizes the article:

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The individual in the high tax bracket and in poor health (dark green box), has the greatest potential to benefit by utilizing an HDHP. Not only will the individual be paying low premiums for a defined out-of-pocket maximum, but he or she will benefit greatly by paying for those expenses with severely discounted after-tax dollars.

The individual with moderate health issues (yellow and red boxes) will need to decide if the tax benefits offered by an HSA will balance the out-of-pocket expenses required in a HDHP. This may be the case if the individual is in a high tax bracket (yellow box), with the out-of-pocket expenses hovering near the maximum allowable contribution ($3,300 for individuals). While the out-of-pocket expenses may be high, the combination of the low premiums and the tax savings from HSA contributions may render the HDHP election worthwhile. However, the individual in a low tax bracket with moderate health expenses (red box) should opt for a conventional plan, and not an HDHP.

Individuals in good health (top row, light green boxes) will pay smaller premiums and few (if any) out-of-pocket expenses. Those individuals in good health are less able to take advantage of the tax-savings offered to the degree that an individual in poor health can.

An individual in poor health in a low tax bracket (lower left) will have their out-of-pocket expenses capped annually. Though still a good fit, this low-tax-bracket-individual will not be able to generate as much tax savings as an individual in a high tax bracket.

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