What Happens To Unused HSA Money?
Unlike an FSA, Health Savings Accounts (HSA) do not require account holders to surrender any unused funds at the end of the year. Money can be left in the account until it is used or it can be invested in an effort to enlarge the account value over time.
The three primary tax-advantaged savings vehicles for medical care available through an employer-sponsored plan are Flexible Spending Accounts (FSAs), Health Reimbursement Arrangements (HRAs), and Health Savings Accounts (HSAs).
We’ll primarily focus on HSAs in this post, but before we get to them, I wanted to hit on FSAs and HRAs so the differences are clear.
In many cases, it’s easy to mix up the details about how each of these plans works.
About FSAs
First, FSAs are an account in which one can save money on a pre-tax basis. All expenses must be used for qualified medical expenses.
The account owner must reimburse any non-qualified expenses from an FSA, but no penalty will be owed (unlike an HSA).
In 2023, the maximum contribution amount to an FSA is $3,050.
Pertinent to the topic of this post, any unused money in an FSA at the end of the calendar year is forfeited by the employee and removed from the account.
This “use it or lose it” characteristic is easily the biggest drawback of using FSAs. It requires highly accurate estimating of medical expenses (which can be challenging) or a stiff penalty for underestimating those costs.
In case you’re wondering, your unused FSA funds go back to your employer.
This doesn’t seem like the ideal scenario for ensuring their interests are aligned with yours, but that’s the way it is.
About HRAs
HRAs are a less popular savings account for medical expenses.
Like FSAs and HSAs, HRAs allow for tax-free contributions and withdrawals for medical expenses.
Unlike FSAs and HSAs, HRAs are completely funded by employers. Furthermore, the maximum annual contribution in 2023 is $1,950.
The good news is you can use an FSA in addition to or with an HRA if you wish to make contributions beyond that of your employer.
You can’t fund these accounts in the same tax year that you fund an HSA.
One important feature of HRAs is that leftover balances typically remain in the account at the end of the year and can be carried over if you remain with the employer who funded the account.
If you leave for another job, you might lose your HRA. If you retire from that job, usually you get to take it with you though the money never really becomes “yours.”
Before I had access to an HSA, I used an HRA for years and was content with the flexibility they offered when coupled with an FSA.
But I still think HSAs are the best.
Unused HSA Money
To clarify, when we use the term “unused” we are assuming this means anything but spending the funds on a qualified medical expense.
If you want to learn more about the nuts and bolts of how HSAs work, please follow the link to our post cleverly titled “What is a Health Savings Account (HSA)?”
Here are some scenarios for that unused money and the potential tax consequences for each.
OPTION 1: It Sits Indefinitely Until You Spend It
One important feature of HSAs is the fact that every dollar that goes into the account is yours, period.
Your employer doesn’t have any control once money goes into the account, even if they put it there.
You also don’t have to worry about surrendering anything at the end of the year if you have a remaining balance.
So, if you don’t have any need for the money, you can just leave it there until you do.
OPTION 2: You Can Invest It
Or you could invest it.
Depending on how much you have in the account and how much you want to leave in cash for actual medical expenses, you could also invest those unused funds.
HSAs are simply on another level when it comes to saving for medical expenses.
If FSAs and HRAs are shovels, HSAs are bulldozers.
HSAs are able to accomplish and produce so much more because 1) you can contribute much more than what can into an FSA ($7,350 vs $3,050 for families) and 2) you can invest your contributions and reap the harvest of compounding interest.
For example, a $5,000 contribution could be worth around $38,000 if invested for 20 years without any other contributions.
If you put $5,000 into the HSA every year, it would be worth around $342,000 in 20 years.
That should cover at least a few trips to the doc when you get older.
OPTION 3: You Remove It (Before Age 65)
You are allowed to remove money from an HSA for a non-medical expense, but you’ll owe income tax and a 20% penalty on the withdrawal (unless you’re over 65).
And that’s about as hefty as withdrawal penalties get from Uncle Sam.
If you pull cash from an IRA or 401(k), you’ll owe a 10% penalty.
There’s also a 25% penalty for failing to take your RMDs, but that’s a slightly different circumstance.
I won’t spend a lot of time here. There are a lot of other places that should be used for emergency cash before an HSA.
Heck, even most forms of debt won’t hit you with a 20-plus percent interest rate.
Do yourself a favor and set up a proper emergency fund so you never have to consider this.
OPTION 4: You Use It (After Age 65)
Ah, but if you wait until 65 there is no penalty.
Withdrawals made from HSAs at age 65 or later are penalty-free, but you will owe income tax on any distribution that isn’t for a qualified medical expense.
In this way, they’re not all that different from a traditional IRA or 401(k). You just have to wait 5.5 years later for penalty-free withdrawals (65 vs. 59.5).
Again, this is a characteristic that provides a lot of freedom to HSA owners and makes the accounts more useful.
The good news is that even if you don’t need the money for medical expenses, there will come a day when you can have access to the money without being penalized for it.
You don’t get that with an FSA or HRA. They are only for medical expenses.
OPTION 5: You Die
Okay, so maybe you didn’t come here for this one, but it may be worth knowing anyway.
If you die and there is still money in your HSA, one of two things will happen:
- If you are married, your spouse will inherit the HSA as if it were their own and can continue to use the account until his or her own death. That is, assuming you haven’t arranged for the account to go to a different heir.
- If anyone other than your spouse inherits the account then they have no choice but to liquidate the balance and pay income tax on the total amount in the year it is inherited.
Every other tax-advantaged account I can think of (and even those that aren’t tax-advantaged) provides more flexibility to heirs than an HSA.
Personally, I think HSAs are a poor way to transfer assets at death and you should try to direct your remaining assets through other means if possible.
Come to think of it, there is a third option for your HSA after you pass. You can leave your HSA to charity if you so desire. The charity will not owe any income tax on the distribution.
If you plan to leave something to heirs and something to charity, directing the HSA to your charity will be more tax efficient unless your heir pays no income taxes.
Conclusion
With such a variety of medical savings accounts available, it can be easy to confuse the rules that govern their use.
Clearly, HSAs provide the highest degree of flexibility, including the opportunity to avoid the forfeiture of any funds remaining in the account at the end of the year.
