What is a Health Savings Account (HSA)?
When Health Savings Accounts are used for qualified medical expenses, they are the only account that allows you to avoid taxes on contributions, earnings, and withdrawals. This triple tax advantage makes them an exceptionally powerful retirement and financial planning tool.
Back around the time that the Affordable Care Act was pushed through Congress, the cost of healthcare was somewhat turbulent (to put it mildly).
Personally, I had always been a fan of my company’s PPO which I lovingly referred to as “Cadillac” level medical insurance.
At that time I was in my late 20s, as was my wife, and we didn’t have any kids.
We were fortunate to enjoy good health and rarely went to the doctor, even for regular check-ups.
So, when the cost of my monthly premium began to rise on the order of 10% or more year after year, my gaze drifted from the Cadillac lineup toward something closer to the Chevy level.
That’s when I learned about High-Deductible Health Plans (HDHPs) and Health Savings Accounts (HSAs).
Put succinctly, a HDHP generally has a lower monthly premium because the insured person carries the risk of a higher deductible for coverage.
For example, in 2023 a single person on a HDHP will pay the first $1,500 of medical care out of their own pocket before insurance steps in to help out for additional costs.
It’s not hard to see how this is helpful for insurance companies, but it leaves the insured with a higher degree of risk.
In order to help mitigate that out-of-pocket risk, Health Savings Accounts (HSAs) were created in 2003 to give people a tax-advantaged place to save for the rising costs of medical treatment.
We’ll get to the benefits of HSAs in a minute, but they’re quite attractive.
In my personal case, for someone who was young and in good health, a lower premium along with an additional place to protect money from taxes is just what the doctor ordered.
(Get it?…huhuh…doctor…HSA…huhuh.)
The Benefits of HSAs
The primary benefit of Health Savings Accounts is the ability to make contributions and withdrawals completely tax free, assuming the withdrawals are used for a qualified medical expense.
That means if you use HSA funds for medical reasons, those dollars are never taxed.
This highest level of tax protection is often called “triple-tax-advantaged” because contributions, earnings, and withdrawals all receive tax-free treatment for medical expenses.
There are not many places one can save money and completely shelter it from taxes.
Additionally, if you have access to an HSA at work and you make your contributions from a payroll deduction, those funds are also contributed before any taxes for social security, Medicare, or unemployment insurance are withheld.
So, that’s what? A sextuple tax advantage?
The payroll deduction provides an additional 7.65% plus (depending on how much is normally withheld for unemployment insurance) tax savings to sweeten the deal even more.
Also, unlike Flexible Savings Accounts (FSAs), any money you don’t spend in a given year rolls over to the following year. It’s not a “use it or lose it” scenario.
And, if you leave your employer you get to take an HSA with you. The funds in the account are always yours.
Finally, once you reach age 65, penalty-free withdrawals can be made from an HSA for any reason, but you will owe income tax on the withdrawal similar to how a Traditional IRA is taxed.
And You Get to Invest the Money
The tax privileges of HSAs are a great advantage, but you can also invest your contributions in securities much like those available in other retirement accounts like IRAs or 401(k)s.
Like I said before, any investment earnings grow completely tax free.
This aspect of HSAs, when coupled with the ability to make penalty-free withdrawals at age 65, makes them a great additional option for retirement saving.
So much so, in fact, that many would argue that HSAs should be your first option for annual savings and contributions.
I don’t disagree. As I’ve already pointed out you can’t find triple tax advantaged savings opportunities like this anywhere, but it does depend a bit on your personal circumstances.
We’ve written another post that explains how you should prioritize the dollars you save.
In summary, you should go after any employer contributions to retirement accounts before pursuing anything else, HSAs included.
If you’re in the rare company of those who are given employer contributions to an HSA, then I would maximize that opportunity before moving on to others like the 401(k).
HSA Eligibility
We’ve already touched on High Deductible Health Plans (HDHPs) a bit and you must be enrolled in a HDHP in order to make contributions to an HSA.
For 2023, the IRS defines a HDHP as “as a health plan with an annual deductible that is not less than $1,500 for self-only coverage or $3,000 for family coverage, and for which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $7,500 for self-only coverage or $15,000 for family coverage.”
This means a single person would pay the first $1,500 of medical expenses out of pocket before their insurance began helping out, and they would have a co-insurance responsibility up to $7,500 of expenses through the end of the year.
You are also not eligible to contribute to an HSA if any of the following apply to you:
- You have other health coverage;
- You are enrolled in Medicare;
- Are claimed as a dependent on someone else’s tax return
Contribution Limits
For 2023, HSA participants are limited to contributions of $3,850 for individual coverage and $7,750 for families.
There are no restrictions based on annual income. You are only required to meet the eligibility requirements we already listed above.
As you invest your HSA, keep those high deductibles in mind. It would be wise to reserve at least some portion of your HSA in cash or cash equivalents in case you experience an unforeseen medical expense.
If all of your balance is invested in securities it would be a shame to have to sell them when the markets are in a lull and you enhance the loss by selling at the worst time.
This is why many plans require some amount of the HSA balance to be held in cash.
Of course, if you have sufficient cash in your emergency fund to cover your deductibles and/or the annual maximum out-of-pocket, then this is less of an issue.
Where to Open an HSA
Assuming you are eligible, most investment companies provide HSA options in addition to their other services.
You will typically find that HSAs opened directly with an investment company provide more flexibility for investing, but you lose the benefits of contributions made before social security, Medicare, or unemployment insurance are withheld.
You’ll need to weigh your options, but typically it will make sense to fund an HSA through payroll deduction if available.
If the investment options within your employer’s plan are unreasonably expensive or otherwise inferior (I had one of those once), it may be worthwhile to shop for a plan on the street.
An Example of How HSAs Work
I have had an HSA to cover my family and I for over 8 years now and I have no regrets.
My employer provides a HDHP option and gives a financial incentive for those who sign up. Those bonus funds are deposited into my HSA on the first day of each calendar year.
Additionally, I’m able to receive more employer contributions by exercising regularly, going to the doctor annually, completing health tutorials, etc.
Because my employer supplements my HSA and my family and I are in good health, the HDHP/HSA option is a no-brainer for us.
The first year made me a bit nervous because any medical emergencies would have meant we’d need to pay our deductibles in cash.
Since our maximum out-of-pocket was well over $10k at the time, we’d have needed to tap the emergency fund to cover it. But, I guess that’s what it’s for, right?
In any event, the amount we saved in premiums annually, coupled with my payroll and employer contributions built the account up enough to cover our deductibles in somewhere around 18 months.
The account grew large enough to cover our maximum out of pocket after 4 or 5 years.
Now it feels like we’re home free because even in the event of a catastrophic medical expense, we know the HSA will cover us until open enrollment. Then, if need be, we could change insurance plans to accommodate our new situation.
We keep about $2,000 in cash and invest the rest.
This is based on our past medical expenses which have never called for more than $2,000 n out of pocket costs, even in the year I had a bike wreck that required surgery.
I suggest that you review your own medical expense history if you can. Most insurance companies keep records of what you pay out of pocket each year.
This can be useful information as you try to establish your own savings rate and asset allocation within the account.
A Sophisticated Approach for HSAs
There is a strategic approach some people take in managing their HSAs that allows them to optimize their contributions.
To begin, there is no requirement that one use their HSA to pay for medical expenses. If you want to pay for those out of other accounts you can.
There is also no time limit on when you request reimbursement for medical expenses from the account.
So, one can pay for a medical expense from an account without any special tax treatment, then ask for reimbursement far, far down the road.
Like, many years down the road.
And why would anyone want to do that?
Because, while they tarry on collecting their reimbursement, the value of the HSA will continue to grow. Any withdrawals you make cannot be replaced so you’ll lose the compounding power of those funds forever.
By leaving capital in the account as long as possible, one maximizes the earning capability of those funds.
You just need to keep up with your receipts.
Which is why I don’t bother using this method.
Sure, I’m not optimizing, but I’m more likely to lose those receipts or completely forget about them than I am to get my reimbursement years down the road.
However, I know some folks get a kick out of using financial levers like this, so go for it if you are so inclined.
How to Evaluate Best Option
To know the best path for yourself you’ll need to know a few things.
First, how much are your annual medical expenses typically? And I mean total expenses, not just the amount you’ve had to pay yourself.
You’ll need to know what the insurance company has paid too because more of this cost will shift to you if you sign up for a HDHP.
You may need to spend some time pulling up records from your health insurance provider for this information.
Next, you should account for how much you’ll save in annual premiums and any employer contributions if those are available to you.
Ultimately, it will come down to how healthy you are. The lower your annual medical costs, the more efficient the HDHP/HSA option becomes.
We have a much more thorough post about evaluating HSAs vs FSAs if you are interested in really getting into the weeds.
HSAs Are Not The Best Inheritance
One final note about HSAs that I don’t see discussed very often is their tax treatment as an inheritance.
HSAs can be inherited by a spouse and basically become their property with no tax impact at all.
However, if inherited by anyone else, the HSA balance must be liquidated by the beneficiary in the year the account owner passes.
This means the entire balance becomes taxable as regular income in the year it is inherited.
There is no option to keep it in an HSA, nor can you delay liquidation.
If the beneficiary happens to be in a low income tax bracket and the account balance is relatively small, then this really isn’t a big deal.
However, for those with higher incomes or large account balances, this could be a significant tax hit.
I wouldn’t say this justifies spending down the account as quickly as possible. After all, the years leading up to your death are when you’ll probably need the HSA the most.
I would at least consider dividing the HSA among as many beneficiaries as you can to minimize the tax hit as much as possible.
Conclusion
Health Savings Accounts are an exceptionally useful retirement and healthcare saving option. If you enjoy relatively good health and have access to one, I’d look into it.
HSAs are the only tax-advantaged account option that afford the opportunity to completely avoid taxes from receipt to expense.
We’ll have more on HSAs in the coming weeks.
