The benefits of Health Savings Accounts (HSAs) have led them to become increasingly popular as a tax-advantaged way to save and pay for medical expenses. And they’re not simply tax-advantaged. They’re actually TRIPLE tax-advantaged if utilized correctly. Essentially, you can contribute pre-tax funds, let that money grow tax-free, and then make tax-free withdrawals from your HSA account.
A quick disclaimer: You can open an HSA only if you have a high-deductible health plan (HDHP). It’s a plan that has a higher-than-normal deductible in exchange for lower premiums. If you are in good health and don’t have many medical requirements, an HDHP may be a good option for you in combination with a Health Savings Account, as the tax advantages will help offset the high deductible cost.
Contributions made to an HSA are tax-deductible. So, you earn money from your job, place funds into your HSA, and then claim a deduction when you file your tax return. The deduction may be enough to push you down a tax bracket, saving you significant money in taxes.
The interest, dividends, and capital gains earned within an HSA grow tax-free, similar to a Roth IRA, but even more tax-advantaged because contributions are deductible. The less you utilize the funds in your HSA, the greater the chances that it will start generating compound returns. This gives you a solid incentive to eat right and exercise because the healthier you are, the better off financially you’ll be!
Finally, you can withdraw funds from your HSA tax-free as long as the expenses qualify. But don’t worry, the list is quite long, ranging from dental checkups to physical exams to prescription medications and even artificial limbs. You cannot, however, pay for insurance premiums with tax-free HSA funds, with COBRA premiums being a notable exception.
Besides tax advantages, a Health Savings Account comes with several other benefits. For starters, there is no ‘use it or lose it’ factor like with a Flexible Savings Account. At the end of the year, any unused funds can be rolled right over all the way to retirement! This brings us to the next point.
Once you get into retirement, you have a few options. Any withdrawals you make for non-qualified medical expenses won’t be subjected to a penalty, but you will have to pay ordinary income tax. You can avoid paying that tax by simply letting the account grow and leaving it as a tax-free gift to your spouse when you pass away.
Besides the tax benefits, some companies offer an employer match, similar to a 401(K). This is essentially free money that you shouldn’t pass up! Keep in mind, though, that employer contributions count toward your yearly contribution limits, which we go into below.
Health Savings Accounts (HSAs) also allow for tax-free withdrawals to cover the cost of long-term care insurance premiums. This benefit is particularly significant to baby boomers, who face an increased likelihood of long-term healthcare needs. In fact, due to longer lifespans, there’s a 70% chance of needing 1-3 years of long-term care! Having the option to use your HSA for this kind of insurance can remove a huge financial burden from your shoulders.
So, the benefits are great, but there are limitations, like with everything else involving investing. Contribution limits are significantly lower than those of an IRA or 401(K). In 2023, for self-only coverage, you can contribute $3,850. For family coverage, that limit is bumped up to $7,750. Fortunately, there is a catch-up contribution of $1,000 for those aged 55 and older.
Besides the limitations, there are other potential drawbacks. You may have noticed I mentioned tax penalties in the paragraph above. While still under age 65, any withdrawals you use to pay for non-qualified expenses will be hit with a 20% penalty, on top of having to pay ordinary income tax! Double-check that all purchases you intend to make are indeed qualifying expenses.
There are penalties for contributing too much to your HSA as well. This penalty comes as a 6% excise tax plus income tax on the amount over the contribution limit. You must correct it to avoid getting hit year after year until you do. However, if you accidentally put too much in and fix it before the year’s end, you may be able to avoid the penalty.
Many HSA providers provide various investment options, such as stocks, bonds, and mutual funds. However, you should be careful what you invest in, as you may need a high degree of liquidity, or you may have to sell investments at a loss during a down market.
One strategy is to simply pay for more minor expenses out of pocket rather than pulling HSA funds to let them continue growing. All the same, your HSA asset allocation should match your risk tolerance and investment horizon.
One last point worth mentioning is the portability of an HSA. Unlike some other benefits that may be tied to a specific employer, an HSA is an account that belongs to you, regardless of your employment situation. This means that if you change jobs, switch health insurance plans, or even experience a period of unemployment, you can still keep your HSA and use the funds for eligible medical expenses.
With triple tax advantages, potential for long-term growth, portability, and the ability to roll it over to long-term care insurance, the HSA is uniquely capable of providing long-term financial security. Unfortunately, those enrolled in Medicare, covered by another insurance policy, or claimed as a dependent cannot take advantage of the benefits the HSA offers.
If you’d like to see if an HSA fits your financial plan, don’t hesitate to click the button below and schedule a consultation!