This may be a controversial statement, but I think health savings accounts (HSA) should NOT be used for paying health expenses. At least not right away. Instead, you should treat an HSA like a high-quality retirement savings account.
Let’s start with the HSA basics. To be eligible for an HSA, you must enroll in a high deductible health plan (HDHP). The HDHP must meet all the various HSA-related requirements set by the IRS. Most of the time, HDHPs have lower monthly premiums and high deductibles. But I’ve seen some HDHPs that have reasonable deductibles (although these are typically employer-based, not ACA plans).
HSA tax benefits
HSAs offer three main tax benefits:
- Contributions are income tax deductible (and exempt from payroll taxes for certain cases)
- Assets in an HSA grow tax free
- Withdrawals are tax free (when used to pay eligible health expenses)
That’s the reason HSAs are often called “triple tax free.” If managed correctly, you pay no tax from start to finish.
In 2023, individuals can contribute $3,850 and families can put in $7,750. (2024 limits are $4,150/$8,300). Individuals over age 55 can make a $1,000 catch-up contribution. Note: this is different than IRAs/401(k)s, which only require you to be over age 50.
Where do people mess up with HSAs?
There are a few ways that people fail to optimize their HSAs.
#1 – Spend down the HSA each year
Most people treat their HSA like the old-style flexible spending account (FSA). FSAs allow you to make pre-tax contributions, but requires that those contributions be spent down each year. In most cases, if you don’t spend your FSA dollars, you forfeit them.
Here’s a funny story about the downsides of FSAs…
When I first started my career in finance, I had an FSA. I maxed it out, but being a young person, I didn’t have many health care expenses. At the end of the year, the FSA provider urged me to spend down the dollars or risk losing them. As a result, I scrambled to buy band-aids, aspirin, and other random over-the-counter health products in bulk. It was a bit of a disaster. In the end, I forfeited a few hundred dollars and some of those band-aids linger in my medicine cabinet to this day. Lesson learned.
Fortunately, HSAs do not require that you spend down the assets each year. But many people still choose to do so. Why is spending down your HSA bad? It comes down to tax free investment growth.
Let’s assume you’re single. You put $3,850 into an HSA for 10 years with a return of 5%. At the end of 10 years, you’ll end up with $48,425. Over 10 years you contributed $38,500, so you have $9,925 of tax free investment earnings. But if you spend down the account or don’t invest it properly, you can expect to lose out on a hefty portion those investment earnings.
Generally, there is no time limit on using HSA dollars to pay medical expenses. Expenses incurred before your HSA was established aren’t eligible. And after you die, you can no longer seek reimbursement.
Beyond that, it’s pretty wide open. If you save your receipts over the years, it’s possible to reimburse yourself for medical expenses from decades ago. The list of eligible medical expenses is fairly extensive. Medicare part B/D premiums are also eligible if you’re over age 65. But not premiums for a Medicare supplement policy like Medigap.
This structure serves two purposes.
- It provides flexibility to invest and grow assets within the HSA for a long time.
- It allows strategic withdrawals to meet retirement cash flow needs.
And that is why I refer to the HSA as a high-quality retirement account.
#2 – Spouses not making separate catch-up contributions
Even many financial advisors miss this. If you are married with family coverage, and each spouse is over age 55, then they can each make separate catch-up contributions.
The main quirk is that you can only contribute to your own HSA, just like an IRA. So if Mary is married to Jim and has a family HDHP with an HSA. For 2023, she can contribute $7,750 plus $1,000 or $8,750 total. And Jim can then open his own HSA (if he doesn’t already have one) and contribute another $1,000. In total, Mary and Jim can contribute $9,750.
Because HSA contributions are tax deductible, it is almost always a good idea to make this extra contribution.
#3 – Not moving your HSA assets
Many people with employer-based health plans default to using the employer-selected HSA provider. This makes sense as employers make direct payroll contributions to employee HSAs. If every employee used a different HSA-provider, then it could get tricky keeping track of contributions. Unfortunately, many employer-selected HSA providers have high fees and/or limited investment choices.
The good news is that HSA assets are portable at all times. And there is no limit on the number of HSAs an individual can have. What if you have $10,000 in an HSA through your employer, but the HSA provider stinks. Then you may consider opening a second HSA with lower costs/better investments. (I think Fidelity’s HSA offering is best). Then you can move $10,000 to the new HSA and invest it. And don’t forget to move future contributions at periodic intervals (say every 6 – 12 months). The goal would be to minimize assets at the “bad” HSA and maximize assets at the “good” HSA.
Bear in mind that you’ll want to keep your old HSA open and intact. This will allow your employer to continue making payroll contributions to that account. A good first step is to check with your employer-selected HSA provider to determine the best way to begin the transfer process.
#4 – Not properly prioritizing HSA contributions
Many people save for retirement in two ways. They either use their employer-based retirement plan (e.g. 401(k), etc.) or an IRA of some kind.
However, because an HSA is triple tax free, it is superior to both Traditional and Roth IRAs in all cases. And once you have received all matching funds in your employer’s retirement plans, the HSA becomes superior.
If you are eligibile to make HSA contributions, then your first savings priority should be to harvest all employer matching funds available in your workplace retirement plan. Then you should maximize HSA contributions to the extent possible. If you can save more, then go back to saving in the retirement plan or an IRA.
What about if you don’t have cash available to make an HSA contribution?
One option is to use appreciated investments in a taxable brokerage account. If you look at the math comparing an HSA to a taxable brokerage account, it’s very often a good idea to sell the appreciated investment to fund the HSA. Read this for more info.
The IRS also allows a one-time IRA withdrawal to fund an HSA contribution. However, you need to maintain HSA-eligible health coverage for one year (the “testing period”) after doing an IRA-to-HSA rollover. If you don’t, the rollover will be disallowed, which will raise significant tax headaches. This “testing period” also applies to Medicare coverage (which is not HSA-eligible).
#5 – Not funding the HSA through payroll contributions
Most employers that offer HSAs as part of their employee benefit package will fund the HSAs using payroll deductions. When done this way, the HSA contributions become exempt from payroll taxes; i.e. Social Security and Medicare, on top of the regular income tax benefits. This represents an additional 7.65% savings. Some employers also offer matching contributions to employee HSAs, and you certainly don’t want to miss those.
Some people choose to go around this system and fund an HSA either by writing a check or using an ACH transfer. In many cases, these folks decided to use a different HSA provider because the employer-selected provider was terrible. However, by not using the payroll deduction system, they are missing out on significant savings.
I’m not sure why the IRS set up a two-tiered system on the payroll tax treatement. Commonsense dictates that the manner in which you fund your HSA shouldn’t have any bearing on the tax treatment. But commonsense doesn’t always prevail.
#6 – Not having a withdrawal plan
One drawback of HSAs is how they are treated upon the death of the owner. If the owner’s spouse is the beneficiary, then the spouse can claim the HSA as their own and no tax is due. But if the beneficiary is a non-spouse, then the full amount of the HSA becomes taxable right away! If this happens, then it would severely diminish the lifetime utility of the HSA.
So it’s a good idea to have a plan to draw down HSA assets. Drawdown strategies exist on a spectrum. The most conservative involves spending down HSA assets each year. The risk here is the lost investment earnings (which we covered before).
On the aggressive end of the spectrum, it’s possible to wait until deep into retirement before withdrawing. If you are married and think you and your spouse will live into your 90s, then it could make sense to wait. However, the risk here is that both spouses die and the entire account becomes taxable to the beneficiaries.
Like most things in life, there is no “right” answer except what suits your personal situation. I often counsel clients to split the difference and consider starting withdrawals within the first few years of retirement.
#7 – Super HSAs
For some families, a Super HSA could make sense. For this, you need to have children who are not tax dependents, but are still covered under your HSA-eligible family health plan (up to age 26).
Essentially, any non-dependent child still on your health plan is treated as a separate “family” under the rules. So that child can make their own family contribution, even though they are an individual.
This situation likely works out best when parents have assets to gift to their children, which they can use to fund their HSA contribution. But if your child is working but not receiving health coverage through their employer, they might be able to fund the contribution themselves. And as I said earlier, funding an HSA should take priority over funding any type of IRA.
#8 – Make sure you get the right health insurance
One last thing to keep in mind is to make sure that you don’t let the HSA “tail” wag the health insurance “dog.” Don’t select a health insurance plan based solely on whether or not the plan is HSA-compatible. If you have significant, ongoing health needs, it might make sense to choose a health plan with a lower annual deductible and out-of-pocket maximum. The savings realized by having the health insurance company cover more of your expenses could outweigh the combined costs/benefits of using an HDHP and HSA.
