Health Savings Account (HSA) - The Best Tax-Advantaged Account in the Universe (When Used Correctly)
I love HSA accounts, especially when they are used to save for health care expenses in retirement. I actually prioritize putting money in my HSA account over contributing to Traditional IRA's, Roth IRA's, and also 401k's after taking full advantage of any employer match. (Always take 100% advantage of any employer match). In this post, I am going to explain the best way to use HSA's so you can make sure that you are getting all the tax advantages that this account has to offer. My goal here is to get you to take action. To either change the way you are currently using your account or if you do not have one to get you to start researching if this type of account might be a good option for your situation.
When most people hear the term "Health Savings Account" or "HSA" they immediately think of medical reimbursement or getting a tax deduction for current health care expenses and while this is true, it does not tell the entire story and actually leaves out the best part.
Before we dive into all the benefits of HSA accounts let's start with a little background information on what a Health Savings Account is. HSA's were introduced in 2004 as a tax-advantaged savings account for people with a qualifying High Deductible Health Plan. This is a very important piece of the equation. In order to open and contribute to a Health Savings Account, you must have a qualifying High Deductible Health Plan. I will explain what an HDHP is later on in this post so you can decide if it makes sense for you and your family, but for now, let's talk about the tax benefits of the HSA.
Tax benefits are the reason people use HSA's. HSA's are known as being triple tax-advantaged. The reason for this is because they are the only account that offers these three big tax advantages:
You get a tax deduction when you contribute to your HSA account. The same way you get a tax deduction when contributing to a 401k or traditional IRA.
The money inside the HSA grows tax-free. You do not pay taxes on any interest, dividends, or capital gains inside the account. This is also similar to a 401k, Traditional IRA and Roth IRA.
You can take the money out tax-free as long as you are using the money for qualified health care expenses. The only other types of accounts with tax-free withdrawals are Roth IRA and Roth 401k's.
Health Savings Accounts are the only accounts in the Universe where you get all three of tax benefits.
Let's talk about some more of the features of the HSA.
- "Not use it or lose it" Health Savings Accounts are not the same as Flexible Savings Accounts. With FSA's you have to use the funds in the account each year or you lose them. This is not the case with HSA's. With HSA's you can invest the funds and let them grow in your account year after year and not worry about using them until you decide it's the right time. This is a big advantage because it allows the funds to grow tax-free for as long as you keep them in there. This is a big part of optimizing the tax benefits available with the HSA.
- Another great feature is that HSA's are portable and you own the account. This means you can take it with you when you leave your employer or you can leave it where it is if you prefer. You are still able to use the funds in your account even if you no longer qualify for an HSA, you will just not be able to contribute to it if you no longer qualify.
- You can also use the funds for your spouse or a dependent even if they are covered under a different health plan.
- There is no income limit or phase-out. Even if you make millions of dollars a year you can still contribute to an HSA as long as you enrolled in a qualifying High Deductible Health Plan.
- The list of qualified medical expenses that you can use the funds for is very long. You can use the funds for deductibles, co-pays, coinsurance, prescription drugs, dental, vision, hearing, medicare premiums once you turn 65, and many more. Here is a link to the IRS publication that provides more information for ways you can use your HSA. https://www.irs.gov/pub/irs-pdf/p969.pdf
The contribution limits for 2020 are $3,550 if you are single and $7,100 for a family. In 2021, they are going up to $3,600 for single and $7,200 for families. You can also make an additional $1,000 catch-up contribution if you are age 55 or older. You are able to make these contributions up until the tax deadline similar to an IRA.
Now let's talk about what a High Deductible Health Plan is and if it might be the right choice for you. A deductible is the amount that you have to pay out of pocket for health care costs before your health insurance plan will pay or reimburse you for eligible expenses. For example, if you have a deductible of $4,000 that means you will have to pay the first $4,000 of medical expenses each year before the insurance company starts to pay anything.
A big reason that high deductible health plans have become increasingly popular is because the higher the deductible, the lower the monthly premium (cost for the insurance). HDHP also have what is called an "Out of Pocket Maximum". This is the "worst case scenario" total amount that you would have to pay in a calendar year. Once you have paid the out of pocket max then the insurance company will cover 100% of eligible health care costs for the rest of the year.
When deciding if a High Deductible Health Plan is right for you the first thing that you need to consider is how much savings you have put away in case of an emergency. The reality is that if you have unexpected health care costs, you will be paying out of pocket until you reach the deductible. A good rule of thumb is to have at least the out of pocket maximum amount available is a savings account in case you have unexpected medical expenses. These plans can be an attractive option if you are young, healthy and very rarely go to the doctor. You want to make sure to keep good records and copies of receipts so you can track exactly how much you have paid out of pocket for when it comes time to reimburse yourself.
A question you might have is what happens if you need the funds for something other than a qualifying health expense? You do have access to the funds and can withdraw them at any time, but if you do not use them for qualifying health expenses then you will owe ordinary income taxes plus a 20% penalty on the amount you withdrew from the account. Obviously, this is not an ideal situation and should be avoided. This does change once you turn age 65. At that point you are able to withdraw the funds for any reason and not have to pay the 20% penalty, but if the funds are not used for health expenses you will have to pay ordinary income tax. In that scenario the account acts very similar to a Tradtional IRA.
So if you are a saver, have a healthy emergency fund and are looking to optimize all the benefits available by using a Health Savings Account then here is what I believe is the best strategy. Instead of using the account like 95% of people who use the funds available each time they have an eligible expense, do not use the funds. Pay your medical expenses out of pocket and invest the money in your HSA account for long term growth. The IRS does not have a time limit on when you must reimburse yourself for medical expenses. You can do it on your timeline as long as you keep records of all of your medical expenses throughout the years. This will allow you to reimburse yourself much later on in life or in retirement once your account has had decades to compound and grow. Approaching the HSA this way allows you to take full advantage of all three tax benefits available with these types of accounts.
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Rich McCormack, CFP®