Why You Need a Health Savings Account
“Triple Tax-Advantaged”. That’s all you need to know about the Health Savings Account (HSA) and why you should have one today.
Just kidding, “Triple Tax-Advantaged” sounds more like a minor league wrestler than something that has the potential to be one of your best investment accounts, but I’ll take you through all the nerdy details and try to convince you.
The Health Savings Account is much more than a simple savings account that allows you to save money tax-free and pay for health expenses. Its slow adoption is probably a combination of not enough information about it along with confusion with a similar account, the Flexible Spending Account (FSA).
Health Savings Accounts Overview
The HSA allows you to save money on a pre-tax basis to pay for qualified medical expenses. You can contribute before-tax contributions through your employer or after-tax money and later deduct it from your taxes. Either way, you don’t have to pay federal taxes on these contributions.
Additionally, you can contribute to your HSA by transferring money from your IRA, although most people can only do this once in their lifetime, but you’re still limited to your annual contribution limit.
You can use these “savings” to pay for qualified health care expenses without paying taxes on the money you pull out. Additionally, many HSA plans allow you to invest the money in your HSA, effectively turning your “savings” account into an “investing” account. This is where things start to get interesting. First, though, let’s talk about HSA qualifications.
Most people will start their HSA through their employer or marketplace plan, but you can pick from many different providers if you don’t like your options. If you receive a contribution from your employer plan, you will need to keep that account, but you can transfer funds into a new HSA that you create from another company. Here’s a great article on picking the best HSA.
Health Savings Account Qualifications
To qualify for an HSA, you need to have a High Deductible Health Plan (HDHP) through your employer or the health marketplace with minimum deductibles of $1,400 for an individual and $2,800 for a family plan in 2020.
You’ll also have to make sure you pick a health insurance plan that allows an HSA. You can search for these on the marketplace or review your employer benefits to determine if there are eligible plans.
Once you find the right plan, you’re allowed to contribute $7,200 for a family or $3,600 for an individual into your health savings account in 2021. Unlike an IRA that has an income phase-out for deductions, the HSA has no income phase-out!
Another advantage of the HSA is any unused funds remain in the account at the end of the year, which is why it’s so much better than a Flexible Spending Account.
Keep in mind the maximum contributions include the amount your employer is contributing, so be sure to factor that in so you don’t go over the allowed amount.
Another cool part of the HSA is if you pass the “last month rule”, you can make a full-year contribution even if you start in November. Here’s how the IRS writes the rule:
“If you are an eligible individual on the first day of the last month of your tax year (December 1 for most taxpayers), you are considered to be an eligible individual for the entire year.”
While this is great, there is one further complication this adds. If you’re trying to game the system by changing your plan in November, making your full HSA contribution, and then changing your plan again in January to a non-HSA plan, you can get hit. You have to pass the “testing period” or you’ll have ramifications. Let’s hear from the IRS:
“If you qualify as eligible due to the last-month rule, you need to pass the “testing period” or you might have to pay taxes on some of the contributions along with a 10% tax penalty.”
If you’re able to make a full contribution through the “last month rule” and you don’t keep your plan for 13 months, you can get hit. Check out this explanation if you need to research it further.
Health Savings Account as an Investment
This is where the HSA gets exciting. The HSA has the advantages of an IRA because you can contribute pre-tax and earnings grow tax-free, but it also has the advantage of the Roth IRA because you can pull money out for qualified expense, without paying taxes on it!
This is where the “Triple Tax-Advantaged” comes into play. Let’s review this sweet triple threat:
- Contribute pre-tax and reduce federal income taxes
- Grows tax-free
- Qualified withdrawals are tax-free
We’ll get into a specific example below, but this “savings account” can essentially become an investment account that rivals or even beats IRA’s and Roth IRA’s. You don’t have to spend the money in the HSA each year, all earnings can grow tax-free, and then after age 65, you have a whole lot of flexibility in how you use your account.
As mentioned above, there are many different providers for HSA accounts, and they offer different investment options. Some providers only offer interest-bearing accounts, while others allow you to invest in index and mutual funds (these are the ones I love).
One important caveat though, if you want to pull your money out of your HSA before age 65 and it’s not for a qualified expense, you’re going to feel the pain with a 20% penalty plus you’ll get hit with income taxes, so you want to make sure you can afford to live without this money (unless you use it for health expenses, of course).
Health Savings Account Qualified Expenses
Let’s go straight to IRS Publication 502 to find the facts on what qualifies as a healthcare expense. (or you can just read my overview, see how easy I make things).
“Generally, qualified medical expenses for HSA purposes are unreimbursed medical expenses that could otherwise be deducted.”
Here are some highlights of qualified expenses:
- Prescription drugs (and insulin)
- Long term care insurance (some limits)
- COBRA (health care continuation coverage)
- Payments of fees to doctors, inpatient hospital care, nursing homes, home health
- Dentures, eyeglasses, contact lenses, hearing aids, wheelchairs, guide dog
- Payments for transportation to a medical center for qualifying medical expenses
- Payments for treatments associated with addiction and weight loss diagnosed by a physician
Most medical expenses can be covered by your HSA. One really interesting use of the HSA is to pay for your Long term care (LTC) insurance. This is tough for most people to buy because it can be fairly expensive and you don’t need it until you need it, but offsetting the pain buying through your HSA account can make it more palatable. You are limited by age how much you can spend on LTC reimbursements.
While you’re limited to only spending on qualified medical expenses under 65, after you reach that age, HSA rules become similar to IRA rules. You can still use your funds tax-free on medical expenses, but you can also pull the funds out penalty-free after 65, although you will pay income taxes, just like an IRA distribution.
EXAMPLE: Why HSA’s are Amazing
If you weren’t convinced by my previous excitement, let me make it clear, HSA’s are amazing. Let’s walk through an example to picture the benefits.
We’ll use a married couple, the Smiths, as our example. They are 40 years old and make $150,000 combined per year, but haven’t started their HSA yet. However, after they read this article, they were convinced to max it out each year. Keep in mind, the HSA allows a “catch-up” contribution for those over 55, which is $1,000 per person (up to $2,000 combined).
Based on this information, the Smiths will save $7,200 per year for fifteen years, then max out their catch-up and save $9,100 pear year for ten years after that. You can no longer contribute to an HSA once you start receiving Medicare.
Starting age: 40
Years of contribution: 25
Contribution: Maxed out ($7,200, then $8,200 after 55)
Expected investment return: 8%
Value at age 65: $548k
You’re telling me I can save over a half-million dollars into a health savings account that’s then used tax-free even starting at the “old age” of 40?? Yes, I am!
Last Tip: Delaying Reimbursements
It may seem counterintuitive to build up a health savings account and then never use it to reimburse your healthcare costs. However, this account is so valuable that if you continue to let it grow, it will become super valuable to you when you’re older and your healthcare costs will inevitably be much higher.
However, if you’re worried about not reimbursing yourself, you can save your medical expense receipts and reimburse yourself at any time. That means if you had a $1,000 bill you paid for out of pocket, continued to save and invest in your HSA, then needed money in a pinch in five years, you can still reimburse yourself $1,000 from the expense five years ago! There’s no time limit to reimburse yourself, but the expense has to have occurred while you had the HSA.
Who shouldn’t use an HSA
Some people won’t benefit from a Health Savings Account. You can no longer contribute to an HSA after you start taking Medicare, so most retirees are out. Also, your healthcare plan may not offer a viable plan that includes an HSA, or the HSA plan may not provide certain coverages you need.
However, if you can pick a plan that covers your needs and provides an HSA, the HSA can be one of your best investment accounts. And of course, if you have questions on any of this, feel free to reach out.
