An IRA or 401(k) is a great savings vehicle because you get to reduce your taxable income when you put money into the account. However, all funds are taxable upon withdrawal. A Roth IRA is attractive because while you don't get an up-front tax deduction, all funds are tax-free upon withdrawal.
What if I told you there is an even better savings account available? One that combines the up-front tax deduction of an IRA/401(k) with the tax-free withdrawals of a Roth IRA? This is an amazing double tax benefit within one account. Further, unlike a regular savings or investment account, all the income from the account itself is also not taxed as it builds up inside the account (just like IRAs and Roth IRAs). In other words, with this special type of savings account, you get triple tax savings! This type of account is called a Health Savings Account (HSA).
The Health Savings Account (HSA) is the ultimate savings machine as it is the only type of account with these triple tax benefits. The image below comes from www.kitces.com.
An HSA is a special type of savings/investment account set up for the intended purpose of paying medical expenses. You can only open and fund an HSA if you have a high deductible health insurance plan that is specifically HSA "qualified". Usually, this is defined as having an annual deductible (for 2019) of at least $1,350 for individuals or $2,700 for family coverage.
It does not matter if your high deductible health plan comes from the health insurance exchange, an employer, or private purchase from a broker. You personally open an HSA account either with your employer's help (as you would when using a 401(k), or if your high deductible health plan is not offered by your employer, by contacting a sponsoring bank directly. The account is yours and stays with you regardless of changes to your insurance plan, employer, or work status.
Getting Funds into an HSA
If you have an employer sponsored high deductible health insurance plan, you can make contributions via pre-tax salary reduction. Some employers make contributions into their employee's HSA's, and like a 401(k) match are also not included in your taxable income. If you have a non-employer sponsored plan, you simply transfer your own funds from a checking account to your HSA in order to make your contribution. In this case, you get your tax deduction on the first page of your tax return.
The IRS sets limits on the total aggregate amount you (and your employer) can contribute each year. For 2019, you can put up to $3,500 in an HSA, or up to $7,000 if you have a family plan. There’s also a “catch up” provision for those aged 55 or older that allows you to contribute an extra $1,000 beyond the limits above. It’s important to keep in mind that the catch-up contribution is based on the age of the person who established the account. An example would be if a 50-year-old established a family plan with their 55-year-old spouse, the couple would be required to wait until the established account holder turned 55.
This year (2019), a family maximum contribution of $7,000 would reduce your federal tax liability by amount $1,540 if you were in the 22% marginal tax bracket.
You can make contributions at any time, even up to April 15 for the previous tax year. The contributions can be spread over the year, or made in one lump sum.
Unfortunately, you cannot contribute to an HSA if you are enrolled in Medicare.
Getting Funds Out of an HSA
Funds in an HSA can be used anytime to pay for a wide range of qualified medical expenses for yourself, your spouse*, or family members* (on your family plan). This includes co-pays, dentist visits, Medicare premiums (part A, B, and Medicare Advantage (but not for Medigap supplemental insurance premiums), prescription glasses, long-term care premiums, and even acupuncture and chiropractic care. However, you cannot take qualified withdrawals for health insurance premiums prior to age 65. You can also take money from your account to reimburse yourself* for past medical expenses - if they occurred after your HSA was established. However, keep your receipts and proof of medical expenses in the rare event that you are audited.
Unlike an IRA, you can withdraw money prior to age 59 ½ and there are no required distributions from the HSA account.
There is a 20% penalty (plus income taxes) paid on the full amount (contributions & earnings) you withdraw from your HSA if it is used for non-medical expenses prior to age 65. But remember, you could pull money out and spend it on a vacation, and as long as you had prior medical expenses after the account was opened. You could always say you are reimbursing yourself for those past medical expenses (yes, this is legal). Once you are age 65 or older, if you use the funds for non-medical expenses the penalty doesn't apply; but the entire withdrawal would still be subjected to income taxes. While not ideal, not only are the odds of not having medical expenses low, even if the withdrawals are taxable, you still end up with the same great benefits as an IRA or 401(k)!
Think of it this way, in retirement (age 65 or older) your HSA morphs into a special type of retirement account where you can withdraw tax-free (like a Roth IRA) for medical expenses, or take taxable withdrawals (like an IRA or 401k) for non-medical expenses.
An HSA is NOT a "use it or lose it" type of account (like a flexible spending account). Unfortunately, this point of distinction has lead to confusion resulting in savers avoiding opening an HSA for fear of losing their contributions if not used during the year.
* If you only have an individual high-deductible health plan, you may use your HSA to pay for the qualified medical expenses of yourself, your spouse, and your dependents claimed on your tax return. Note, if you are reimbursing yourself for the past medical expenses of your spouse, these expenses must have occurred after your marriage date (i.e., you cannot reimburse yourself for your spouse’s qualified medical expenses before marriage).
What Does the Money Do While Inside the HSA Account?
An HSA operates much like a checking account with online banking features, a debit card, and little to no interest earnings. While you can let the money sit in the cash account so that it is liquid and safe, you can also invest some or all of the balance (that you don't plan on withdrawing in the short-term) in mutual funds.
For those who fund their HSA and use it for medical in the same year, they should keep the money in the cash account. However, if you have little expected medical costs, or are willing to NOT tap into your HSA, the best bet would be to invest your balance. Investing your HSA dollars is the only real way to take advantage of the back-end tax benefits: tax-free growth. However, this would require that you not only fund the HSA, but that you also pay your current medical expenses out of your own pocket instead of using the HSA. This can be hard, but it works for those with the cash flow (or other assets) to do so.
In fact, this is the ideal scenario: fund the account; avoid withdrawals; invest the balance; and let it grow tax-free for your future retirement medical expenses.
What Happens to the Account After I Die?
Assuming you are married, and your spouse is your beneficiary, the account becomes your spouse’s HSA by having the funds move into a new HSA in their name. There are no taxes or penalties to change the account over to a spouse. If you are not married, the account ceases to be an HSA upon your death. It must be distributed to the beneficiaries of the account (or your estate if you don’t have named beneficiaries). There is no tax penalty on distribution, but the full distribution is taxable income to the non-spouse beneficiaries. Although, this taxable income may be reduced for any qualified medical expenses which you incurred prior to your death and paid by the beneficiary within one year after your death.
What else should I consider about an HSA?
As you search for an HSA provider, be sure to examine whether it offers an easy-to-use web interface, a suitable array of investment choices (perhaps FDIC insured for those that are money market), low or non-existent monthly maintenance or transaction fees, and beware of minimum balance requirements. Should you wish to move your HSA in the future, it can be rolled over to a different provider. One website, www.HSASearch.com, lists several hundred providers and allows you to compare features among them.
In summary, the benefits of an HSA are:
- Front-end tax break. Your contributions are tax deductible which reduces your taxable income and your tax.
- Back-end tax break. The account grows tax-free as long as you spend them on qualified medical expenses.
- On-going tax break. The earnings while they are in the account are not taxable. In other words, you don't get a 1099 each year where you must report the earnings on your tax return.
- You never lose funds. They stay in the account for your entire life, with no penalty if you don't spend them.
- Withdrawals are never taxed, as long as you spend them on qualified medical expenses.
- You can spend it on you, your family, or your dependents for medical expenses.
- You own it. It stays with you and is portable, regardless of your employer or changes to your insurance plan.
If you're eligible for an HSA and you have the ability to fund it, you should open one right away and take advantage of the benefits of the ultimate savings machine!