Health Savings Accounts (HSAs) recently turned 10 years old and, like any pre-teen, are growing rapidly. Serious savers are embracing their immediate tax benefits and learning of their even greater long-term value. The basics of HSAs are largely understood, namely, that they are coupled with a high deductible health plan and allow you or your employer to contribute pre-tax dollars which grow tax-deferred until withdrawn tax-free for qualified health care expenses. In this article, we seek to explore some of the lesser-known aspects of HSAs.
Ways to Use HSAs
The first way to use an HSA is as a pass-through account which allows you to deduct 100% of your health-related costs. Dollars flow in to the account and flow out throughout the year to cover current medical expenses. The account doesn't build. (For more, see: Pros and Cons of a Health Savings Account.)
In the second way, tax-deductible dollars are contributed to the HSA, and no (or few) expenses are paid from it. You may be extra healthy, or you may pay your expenses with money outside the HSA. In either case, the HSA grows tax deferred, and ultimately tax free if used for future medical costs. Year after year the account builds. Why do it this way? Either you have the cash flow to pay your medical expenses (or you are healthy) and you are serious about saving for your future health needs in a tax-advantaged manner.
What to Consider
- Each year you are eligible, you can make a tax deductible contribution. In 2016, if you had an individual plan, you could contribute $3,350 and a family $6,750. If you are over 55, you could add $1,000 more. For 2017, the amounts are $3,400 and $6,750.
- You have until the April tax deadline of the year following the tax year to make the contribution. This gives you extra time to figure what you can contribute and to locate the money to do so.
- If your employer is contributing to your HSA but not reaching the maximum allowed, you can top up your contribution. You'll get the deduction on your taxes.
- If you have a child who is working and is covered by an HSA, you might want to encourage them to start an HSA and help them to "top up" the contribution.
- You can't deduct a health expense from an HSA which was incurred before the HSA was established. As a result, you may want to set up your HSA sooner and before a health incident occurs.
Should an HSA Balance Be Invested?
The landscape of HSA custodians has changed materially in the last 10 years, for the better. There are more players in this market which has led to more competition on fees and more investment options. In addition to bank account options, several HSA custodians offer low cost investment choices (see references below). Fees are still typically higher than for IRAs, but this may also change as competition heats up. If your employer is contributing to your HSA, you may need to use the one they designate, but you can rollover balances periodically to a custodian of your choosing which may save on fees. (For more, see: Rules for Having a Health Savings Account (HSA).
This brings us to the next question - should you take risk with the money in your HSA? The answer “it all depends” is not helpful, but very true in this case.
If you are treating it as a transactional "in and out" account, it is not a good idea. But, if you have a 5, 10, 20 year-year time horizon, then you should invest. A good idea is to keep the equivalent of your annual deductible in a bank account and invest the rest. Don't invest 100% in stocks. Look for a balanced mix of stocks and bonds. Health care costs continue to rise, so it is important that you invest to maintain purchasing power.
HSA Withdrawals:The Secret to the Sauce
- Withdrawals are tax free if used for qualified medical expenses that occur after the HSA is established.
- Even if you are no longer eligible to contribute to an HSA, you and your family (spouse and dependents) can use the HSA to pay for qualified expenses.
- Qualified medical expenses include things that may not be covered by your health plan - namely dental bills, eyeglasses, eye exams, home improvements for medical reasons and acupuncture, to name a few.
- You generally cannot use the HSA to pay health insurance premiums except for:
- You can deduct expenses which you incurred in prior years (but after the HSA) was established.
These rules make the HSA an interesting strategy for saving for future medical costs. There's a strong argument to be made for contributing to an HSA even before you max out your 401(k), though we recommend maxing both out. (For more, see: How to Effectively Utilize Health Saving Accounts.)
Now that you are getting hang of this, let's think about the implications of the withdrawal rules. You can keep records of your unreimbursed medical costs for years after you first start your HSA and if the time comes and you need some extra cash, you can make a tax-free withdrawal. If you fear you are behind in your retirement savings, this is a way to boost savings in a tax-deferred, tax-free vehicle, and at the same time, keep your options open. In retirement you can use the HSA for Medicare premiums, LTC premiums, as well as costs not covered by Medicare. It doesn't get better than that.
Nothing comes without a few caveats and this is no exception. Be careful that you keep good records. You can't deduct the expenses and use them for justification of an HSA withdrawal. That's double dipping. Also beware that when you are Medicare age (65), you may not be eligible to contribute to an HSA any longer if you enroll in Medicare Part A. Proceed with caution as you approach 65.
As the HSA landscape has matured, health savings accounts have become a very effective saving vehicle for medical expenses in retirement. If you are able to contribute to an HSA and let the balance grow, you will be rewarded with triple tax-free withdrawals later. (For more from this author, see: Sometimes Paying Down Debt Isn't a Good Idea.)