Health insurance and planning for inevitable expenses in the future is a fundamental part of any financial plan. One tool Millennials should be taking advantage of, if available to them, is a health savings account.
The benefits of a health savings account (HSA) extend beyond their triple-tax-advantaged status to the ability to invest funds within the account and have it act as a shadow IRA. This article will explore the benefits of HSAs, why Millennials should be taking advantage of them, and give a glimpse of what to expect in the future as healthcare expenses continue to rise.
Prerequisite to an HSA
First and foremost, it’s important to understand who actually qualifies for an HSA. To be eligible you must be currently enrolled in a high-deductible health insurance plan (HDHP). In 2018, that equates to a deductible greater than $1,350 for an individual and $2,700 for a family. You may end up paying more out of pocket for medical expenses, but the tax benefits will likely outweigh the additional amount you pay for the deductible.
For 2018, you’re also allowed to contribute up to $3,450 for individuals or $6,900 for families. If you’re in the 24% tax bracket and make the maximum contribution, that saves $828 in taxes for the year, which can easily equal the difference in out-of-pocket expenses between a low-deductible plan and a high-deductible plan. Plus, this is before you factor in the added benefits an HSA actually provides. (For related reading, see: How to Qualify to Contribute to an HSA.)
Benefits of an HSA
HSAs are Triple Tax-Advantaged
What does triple tax-advantaged mean? For perspective, 401(k)s and IRAs are double tax-advantaged accounts. When you make a contribution to a 401(k) or IRA, you get the benefit of deferring income tax on that money until withdrawals are made in the future, and the funds in a 401(k) and IRA are invested, but paying taxes on dividends, capital gains, and interest is deferred. This deferral of taxes inevitably results in a greater return than if the funds were invested in a taxable account which has to pay taxes in the year dividends, capital gains and interest are realized.
HSAs have both of these tax benefits plus another: The funds can also be withdrawn tax-free for qualified medical expenses. Even if you never invest the funds in your HSA, and you deplete the account each year for medical expenses, you’re still using funds that never get taxed. There isn’t another account currently available with the tax benefits HSAs are given.
The term "shadow IRA" refers to the ability of an HSA to act as a supplementary retirement account that mimics an IRA once the account owner reaches age 65. Not only can the funds be used for future medical expenses tax-free, once the account owner reaches age 65, it effectively becomes an IRA from which funds can be used for anything without paying a penalty. For example, if an HSA owner withdrew funds prior to age 65 for anything other than medical expenses, they would owe ordinary income tax plus a 10% penalty on the withdrawn funds. However, upon age 65, withdrawals are only subject to ordinary income tax, just like an IRA. (For related reading, see: High-Income Benefits From a Health Savings Account.)
Taking Advantage of Compounding
There’s one last benefit to HSAs: They allow you to invest the funds you contribute, meaning you can benefit from decades of compounding in another tax-advantaged account. Rather than leaving the funds in cash, where they’ll actually lose value due to inflation, invest the funds you have saved in your HSA.
To get the most value out of your HSA, if you’re a healthy individual, consider maxing out your contributions each year and paying out of pocket for medical expenses if they fall within your deductible. This will allow you to accumulate funds to invest in the HSA. In fact, it can be argued that HSAs should actually be maxed out prior to other retirement accounts, due to the fact they can act as a retirement account and a healthcare expense account.
Why You Should Open an HSA, if Eligible
The estimated cost of healthcare expenses in retirement for an individual retiring today is roughly $189,000 for men and $214,000 for women. When our time comes, we’d better be prepared, and HSAs are currently the best way to hedge our risk of outliving our money due to increasing healthcare expenses, which we’ll all inevitably face as we grow older and our health deteriorates.
(For more from this author, see: The Top 5 Financial Mistakes Millennials Make.)