Health savings accounts (HSAs) were first authorized in 2003 as a tax-friendly way to save money for healthcare expenses. They’re a benefit designed to encourage use of high-deductible health plans (HDHPs), which usually involve a lower monthly premium but higher out-of-pocket costs until deductible and out-of-pocket limits are reached. We’re very fortunate that lawmakers created HSAs. Though they aren’t technically a retirement account, in some ways they’re better than even the venerable Roth IRA itself!
The Benefits of HSAs
HSAs incorporate some of the best features of both traditional and Roth accounts. Here’s why they’re referred to as “triple tax-free.”
Money that goes in an HSA account is excludable from taxable income, similar to contributions to traditional IRAs. But unlike IRAs, you can make deductible contributions to HSAs regardless of how high your income might be. If you directly contribute to an HSA via payroll deductions, a payroll tax of 6.2 percent for Social Security and 1.45 percent for Medicare is avoided. Even 401(k) contributions are subject to payroll taxes! This benefit is easy to overlook but yields an immediate 7.65 percent return on money directed to your HSA.
An HSA account can be invested in the markets just like an investment portfolio, and it grows in a tax-deferred/tax-free manner, similar to most retirement accounts. Unlike flexible spending accounts (FSAs), there is no use-it-or-lose-it stipulation. These funds are yours forever.
When HSA funds are eventually withdrawn and spent on approved healthcare expenses, those withdrawals aren’t taxed either, much like a Roth IRA. Though you got a tax benefit when you funded your HSA, you don’t owe taxes on the back end either — it’s hard to beat that!
Besides the points above, there’s another unusual benefit of HSAs to note. Imagine you’re out of pocket for $5,000 of surgical expenses. Your first instinct might be to run the charge on your HSA card or immediately reimburse yourself, but if you do that, you’re probably leaving something on the table.
Assuming you correctly assemble the documentation, there is no deadline to reimburse yourself for medical expenses. For example, you could wait five years to take your $5,000 tax-exempt medical expense reimbursement from the HSA. By waiting, your $5,000 still comes back to you, but it would have had five years to grow in your HSA tax-free, and any earnings on that money left behind continue to compound and grow within the HSA.
Is it possible to have “too much” money in your HSA? If you’re the healthiest person in the world and never spend a dime on medical care, you’re still in great shape when it comes to your HSA (apologies for the bad pun). Once you reach age 65 or if you become disabled, you can withdraw from your HSA for any reason, without penalty; however, those withdrawals are taxable as ordinary income. So, in this scenario, your HSA eventually functions much like a traditional IRA.
The Downsides of HSAs
If you take money out for nonmedical expenses before age 65, you’ll pay ordinary income taxes plus a 20 percent penalty. As discussed above, there are many ways to access that money without penalty, but, just like with an IRA, if you need the money early without a plan in place, you’ll pay meaningful tax and penalties on those withdrawals.
Another downside is that HSAs aren’t ideal for estate planning. If you pass away, your spouse will inherit your HSA and it becomes just like it was their HSA all along, no problem. However, if there is no surviving spouse, the beneficiary must take a distribution of the entire balance of the account, which means the entire account’s value is taxable as ordinary income that year.
Therefore, it makes sense to spend down your HSA as you age. That shouldn’t be difficult — for most people, medical expenses increase later in life. You even can use HSAs to pay some or all of your long-term care premiums.
What It Means for You
If you fund an HSA, save appropriate documentation of healthcare expenses and try to avoid swiping that card — you might be surprised at how quickly your HSA could play an important role in helping to secure your financial future.
Gene Gard, CFA, CFP, CFT-I, is a Wealth Manager with Creative Planning, formerly Telarray. Creative Planning is one of the nation’s largest Registered Investment Advisory firms providing comprehensive wealth management services to ensure all elements of a client’s financial life are working together, including investments, taxes, estate planning, and risk management. For more information or to request a free, no-obligation consultation, visit CreativePlanning.com.
