Article Updated for 2021
The Amazing HSA
When talking with people about their employee benefits, there are certain topics that everyone wants to talk about because they’re exciting and fun to discuss (401(k)s, stock options, anything investment related). Then, there are other topics that, when mentioned, generally causes people’s eyes to glaze over, toes to curl up, and invokes a strong involuntary reaction to do ANYTHING ELSE than to discuss that particular topic (disability income insurance is extremely important, but I’d recommend against using it as a conversation starter at a cocktail party). So if I were to bring up the topic of Health Savings Accounts (HSAs), I think most of you would group the topic into the latter category more so than the former. In fact, I’m pretty sure some of you are frantically reaching for your mouse to find something else to read. Well, before you go, let me quickly give you 5 reasons why I think HSAs are amazing and why I think you’ll think they’re amazing too.
What is an HSA?
Before we can go into what makes these things amazing, let me quickly clarify what an HSA is. The main purpose of the HSA is to provide a savings account to help individuals pay expenses for any qualified medical expense, including deductibles, co-pays, and coinsurance, along with any other qualified medical expense that is not covered by your health plan. Anyone that is enrolled in a high deductible health plan (HDHP), defined in 2021 as having a minimum deductible of $2800 for a family ($1400 for an individual) and maximum out of pocket amounts of $14,000 ($7000 for an individual), can contribute to an HSA. For 2021, families are allowed to contribute up to $7200 (plus an additional $1000 for anyone age 55 or older), and single individuals are allowed to contribute $3600 (plus the $1000 catch-up for anyone 55 or older).
What's So Amazing About An HSA?
1.) They are extremely tax efficient
When it comes to tax efficiency, the HSA is in rare air, as it offers three significant tax advantages that many refer to as the “tax trifecta.”
Tax Deductibility: Contributions to an HSA are on a pre-tax/tax deductible basis (pre-tax if done through payroll deduction, tax deductible otherwise), meaning that contributions reduce your taxable income for the year (If you make $75,000 and put $5000 into an HSA, your taxable income is reduced to $70,000). To make it a little bit sweeter, if contributed via a payroll deduction, contributions are also not subject to the 7.65% FICA tax that goes towards Social Security and Medicare. Even your 401(k) and IRA contributions can’t dodge the FICA tax, so this is a pretty nice value add for contributing to an HSA.
Tax-Deferred Growth: Similar to your 401(k), 403(b), or other employer sponsored retirement plans, contributions to an HSA grow on a tax-deferred basis, meaning you don’t have to pay taxes on any growth in the account until you withdrawal money out of the account.
Tax-Free Distributions for Qualified Medical Expenses: If used for a qualified medical expense, distributions from an HSA are tax-free distributions! It doesn’t even have to be pulled out in the same year as the expense incurred! The only requirement is that the medical expense occurred after the individual began contributing to the HSA.
Think about that for a second, you reduced your taxable income for the year when you contributed to the HSA, the growth in the account (more on this shortly) grew tax deferred, and then when you made withdrawals for qualified medical expenses you pulled it out tax-free! That’s amazing!
2.) HSA account balances can be invested and carry over from year to year
Unlike Flexible Savings Accounts (FSA), contributions to an HSA do not have to be used up in a given year. Rather, the balance in the account carries over from year to year and, similar to your retirement accounts at work, can be invested in mutual funds, stocks, bonds, and other investment vehicles to further grow the account over time. Unfortunately, most people who have an HSA are not taking advantage of this valuable feature as only 3% of HSA accounts have money in investible assets (other than in cash), according to a study done by the Employee Benefit Research Institute in 2017!
3.) There are no contribution restrictions based on income
Unlike some other retirement accounts, such as the Roth IRA, that restrict high-income earners from making contributions, individuals and families can max out annual contributions to an HSA, regardless of income. For those of you who have maxed out your 401(k) contributions for the year and are looking for an additional place to get a tax deduction and tax-deferred growth, the HSA is a solid option.
4.) HSAs don’t have RMD requirements
One annual source of frustration for many retirees is having to withdraw money from retirement accounts that they don’t need yet and pay taxes on that money in order to satisfy the Required Minimum Distributions (RMD) requirements of those accounts. Many of the most popular types of tax-deferred retirement savings accounts, including 401(k)s, 403(b)s, and Traditional IRAs, require that, once an individual is retired and reaches age 72, they must begin to make age-based minimum withdrawals from their retirement accounts. As the individual gets older, the portion of the account that must be withdrawn gets larger and larger. This is often a headache because not only will this force retirees to pay taxes on that money (with a possibility of pushing their income into a higher tax bracket for the year), but it will also prevent that money from continuing to grow tax-deferred.
HSAs have none of these RMD requirements, meaning that people can continue to defer growth in the account for as long as they wish. Some of you may be asking, “why does this matter if I’m still decades away from retirement?” Well, that’s a good question, and one we’ll address in reason #5…
5.) HSAs can be utilized as a long-term vehicle for retirement savings
The main reason that the HSA exists is to pay for short-term qualified medical expenses that occur while enrolled in a HDHP, but these accounts can provide significantly more long-term value for individuals that have the means to pay for their current medical expenses out-of-pocket. Given the aforementioned tax efficiencies, the ability to invest the money in the market, and the fact that the HSA does not have any RMD requirements, the HSA provides a significant retirement planning opportunity for those that take advantage of it.
Instead of thinking of the HSA as solely a short-term solution for current health expenses, I’d encourage you to think of the HSA as a bucket of money earmarked for retirement and invested as such (similar portfolio construction to your other retirement accounts) with the designated purpose of paying for healthcare costs during retirement. Medical expenses are one of the chief costs that retirees incur during retirement. According to Fidelity, a 65 year old couple in 2021 will pay, on average, $300,000 in after-tax health expenses over their retirement years. Given how people are living longer and longer, there’s a good chance that that number will rise over time. By investing and earmarking the HSA as the primary funding mechanism for health expenses during retirement, individuals can effectively get another bucket of money (along with the Roth) where they can make tax-free withdrawals to cover their medical expenses and allow their other tax-deferred buckets of retirement savings to be better used for other expenses.
But what if you remain quite healthy in retirement and have limited medical expenses? The HSA is flexible in that after you reach age 65, withdrawals that are not used for qualified medical expenses will be treated the same as pulling money out of your 401(k)! When you make a withdrawal for something other than a qualified medical expense, you merely pay income taxes on funds withdrawn (please note that any funds withdrawn before age 65 for a purpose other than paying for a qualified medical expense will be assessed a 20% penalty along with payment of income tax).
Anyone can take advantage and benefit from this strategy, but individuals in their 20’s, 30’s, and 40’s could especially benefit by beginning now to put money into these accounts. The fairly low contribution limits will take a few years to accumulate a sizeable chunk of money into these accounts, but by consistently contributing over a couple of decades and by the miracles of compounding interest, these accounts have the potential to grow into a decent-sized, tax-free (if used for medical expenses) pot of money for retirement.
A Couple of things to be aware of before contributing to an HSA
While HSAs can be very beneficial in the right situation, here is a couple of things to keep in mind before making a contribution. First, you can only contribute to these accounts if you are enrolled in a High Deductible Health Plan. These plans, as it says in their names, are high-deductible plans, meaning you have to pay higher out-of-pocket expenses than a traditional health plan before your health insurer is on the hook for any of the cost of care. Because of this, I’d suggest having some money saved up in an emergency fund before transitioning to a high-deductible plan. Should you choose to make a transition to a HDHP with fairly limited resources available, I’d suggest keeping the majority of your HSA in cash in the first few years until you have enough in your HSA (or separate savings account) to cover your medical expenses. Also, if you are not in the best of health, it might make sense to forgo the HDHP completely and stay on a traditional health plan through work.
Finally, please note that, if used properly, HSAs can be a very useful account to have, but they should not be thought of as a substitute for a checking or savings account. If funds in these accounts are withdrawn before age 65 for something other than a qualified medical expense, the amount withdrawn will be taxed and will also be subject to a 20% penalty. You don’t want your money going to waste unnecessarily, so make sure you have adequate savings in a traditional checking or savings account.
Conclusion
So there you have it! I hope that after having read this article that you have a newfound interest and excitement for HSAs. Whether using them for retirement savings, or just to get the tax deduction in the short term, these are useful accounts and might be a good fit for you and your family.
If you want to have a more detailed discussion on whether a Health Savings Account is the right fit for your particular situation, feel free to email me at daniel@sweetgrassfp.com or schedule a free introductory consultation.
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Disclaimer: This article is provided for general information and illustration purposes only. Nothing contained in the material constitutes tax advice, a recommendation for purchase or sale of any security, or investment advisory services. I encourage you to consult a financial planner, accountant, and/or legal counsel for advice specific to your situation. Reproduction of this material is prohibited without written permission from Daniel Patterson, and all rights are reserved. Read the full disclaimer here.
