A health savings account (HSA) is unique in the landscape of tax-preferred investment accounts, as it is the only type that enjoys both the benefit of tax-deductible contributions and tax-free distributions (for qualified medical expenses).
In fact, savvy investors can use HSAs as a savings vehicle, rather than the purpose for which they were originally created: to cover the deductible on the high-deductible health plans they are paired with.
Read on to discover how HSAs can be used to save money for health costs, and as a clever way to grow tax-advantaged savings.
What is a Health Savings Account?
A HSA is a tax-advantaged account that works in conjunction with an eligible health plan that allows the participant to save tax-free money for eligible medical expenses. Money in an HSA rolls over year after year and is owned by the participant even if they change jobs or health plans.
An HSA covers eligible expenses for the account owner, their spouse and their dependents. This means you could pay less in taxes and keep more spendable income.
In order to qualify for a HSA, you must first be enrolled in a health insurance plan that qualifies as a high-deductible health plan (HDHP). Generally speaking, these plans will have a minimum annual deductible for an individual of at least $1,400 with an out-of-pocket maximum of $7,050 or less. For a family (single plus one or more), the minimum annual deductible is $2,800, with a maximum out-of-pocket of $14,100.
Now, we know what you are thinking: “A $7,000-per-year deductible! Are you mad?”
That’s the usual response we see, but focusing on the high-deductible part of the health plan can prevent people from appreciating the tax shelter aspect of the HSA account.
These plans are not for everyone, as they certainly have their pros and cons – which widely vary depending on one’s unique situation. Review these considerations before committing to a HDHP.
The Pros of a High-Deductible Health Plan
- Lower Premiums: Premiums are typically lower than Point of Service (POS) or Preferred Provider Organization (PPO) plans.
- Network Availability: Networks are not necessarily narrowed, as with Health Maintenance Organization (HMO) plans.
- Rare Users Save: People who rarely use their health insurance benefits may save money.
- Avoid Market Rate: Out-of-pocket expenses are not the market rate, but the negotiated rate between the healthcare provider and insurance company.
- HSA Eligibility: Policyholders covered by an HDHP can open a HSA and deposit funds into a tax-free account to cover out-of-pocket expenses until the deductible is reached.
The Cons of a High-Deductible Health Plan
- High Deductible: It’s right there in the name, these plans carry high deductibles.
- Out-of-Pocket Expenses: Most healthcare expenses – like prescriptions, office visits and diagnostic tests – are completely out-of-pocket until you reach your deductible, so HDHPs are not ideal for those managing a chronic illness, those pregnant or planning to become pregnant, or those with small children.
- Care Avoidance: Due to the high deductible and out-of-pocket expenses, some policyholders may not seek the medical treatment, which could lead to a worsened medical condition later in life.
- Disqualifications: HSA participants can’t be covered by another non-HSA qualified plan, enrolled in Medicare, claimed as a dependent or have a Flexible Savings Account (FSA).
When doing the math of HDHPs, consider the following costs:
- Copays and Coinsurance
- Out-of-Pocket Maximum
- Employer Contributions
For the reasons outlined above, HSAs – and HDHPs – are ideal for healthy people who don’t anticipate incurring high medical expenses until later in life.
By then, policyholders could have a sizable fund that can be used to pay for qualified medical expenses such as Medicare premiums, drug costs, dental bills (which are not currently covered under Medicare), long-term care and more. See IRS Publication 502 for a complete list of the qualified medical expenses under HSAs.
How to Use HSAs As a Savings Vehicle
While most people use their HSAs during their working years to pay for medical expenses that aren’t fully covered by insurance, there’s a more savvy way to use the accounts.
Once the HSA is fully funded (the balance reaches a certain threshold), account holders can invest the money into mutual funds for long-term savings.
After reaching that threshold, some investors don’t use the money in their HSAs to cover medical expenses even if they do get sick. Instead, they pay medical expenses from non-HSA sources and leave the HSA balance to grow through compound interest. After all, there will always be plenty of medical expenses to be paid later in life, like Medicare premiums and long-term care services.
Of course, you can use the HSA to pay those qualified medical expenses in retirement, but there’s another option: You can reimburse yourself for prior expenses using money in your HSA. For example, you could spend $1,500 out-of-pocket on a root canal in 2022 and reimburse yourself using the HSA 10 years from the procedure. This allows the $1,500 to earn 10 years’ worth of investment returns. If you decide to take this route, keep receipts and proof of payment in case the IRS audits you, or the HSA custodian raises questions.
Retirement Uses for Your Health Savings Account
Because of the unique treatment of the HSA, they have created a wrinkle in the traditional approach of funding retirement accounts. Given the inevitability of medical expenses in retirement, arguably the best savings account for retirement (or at least for a portion of retirement expenses) is to use an HSA for retirement over an IRA alone.
In other words, for any retiree that is saving for both medical expenses in retirement and also all of their other retirement goals, using a combination of an IRA – for most retirement expenses – supplemented by an HSA – as a “retirement health savings account” – may be the most tax-preferred way to save holistically.
Health Savings Account Contributions and Limitations
HSA annual contribution limits are determined every year by the IRS, and eligibility rules apply. The maximum HSA contribution in 2022 is $3,650 for an individual and $7,300 for a family policy. There’s an additional $1,000 catch-up contribution allowed for those who are 55 or older.
You can front-load, back-load, stagger, or contribute in equal installments throughout the year. Contributions can be made up until the tax-filing deadline for a tax credit.
Contributions made by an individual are deductible from gross income, and contributions made by an employer to the employee’s account are excluded from gross income.
What Happens to the HSA If You Die
When you open a HSA, you’ll make a beneficiary designation to whom the account will be transferred to upon death. If the named beneficiary is a spouse, they can continue the HSA in his/her own name, continuing the preferential tax treatment, including future tax-free withdrawals. This form of HSA spousal rollover is similar to that permitted for retirement accounts.
If the beneficiary is not a spouse, the HSA is closed and the remaining funds are transferred and taxable.
Ultimately, a HSA is best for those who can afford to contribute to retirement accounts, have an HSA, and have the cash flow or reserves to pay medical expenses out of pocket. Presuming, of course, that the HSA dollars will be invested for growth in the long run, and not held in a cash or low-return holding account.
Have questions? Schedule a complimentary consultation with our team of financial advisors.