One of the best tax-advantaged accounts is the HSA, or Health Savings Account. When used strategically, its benefits can be immense. As funds accumulate, it becomes a retirement account. As qualified medical expenses accumulate, it becomes an emergency fund.
What is an HSA?
An HSA, short for Health Savings Account, is designated for medical expenses. It’s available to individuals with high deductible health insurance plans so they can pay for expenses with pre-tax money. The contribution limits are modest, $3,450 for an individual and $6,850 for a family. Those 55 or older may contribute an extra $1,000 in catch up funds.
Contributions are tax deductible and reside in an account to be withdrawn, tax and penalty free, for reimbursement of qualified medical expenses.
Once you qualify for an HSA through having a high deductible plan, you can make annual contributions up to the annual limit. There is no deadline for using the funds. If you later switch to a traditional health plan, you may still keep your existing HSA (although you are no longer eligible to make contributions).
Funds can be invested much like any brokerage account. These options for this vary across institutions.
It’s the best traits of the Roth IRA and those of the 401(k) all rolled into one. Pre-tax money goes in, grows tax-free, and tax-free comes out.
How to best use your HSA
If you have a high deductible health plan and are eligible for an HSA, you should open one immediately. How you prioritize funding compared to other savings is somewhat dependent on your own situation.
- If you incur any medical related costs, you should, at minimum, contribute that amount (up to the annual contribution limit, of course) and enjoy the tax deduction on those expenses.
- If you are financially capable of delaying reimbursement for those incurred costs, you can keep the funds in the account to grow tax-free and get reimbursed later. Remember, there is no time limit on when you need to file a claim for reimbursement.
Even if you are not expecting any medical-related expenses, you can contribute to your HSA and think of it as a retirement account.
Saving funds for retirment
It’s probably a safe assumption (I know, I know… that old saying about assuming) that you will incur medical-related costs later in life. While health insurance premiums are not a qualifying expense, Medicare costs are. As our bodies get older, we’ll likely have a use for HSA funds one day down the road.
Should you miraculously avoid incurring medical-related expenses, you can withdraw the money penalty-free after the age of 65. You will owe tax on the disbursement, but that’s no worse than withdrawing from your other retirement accounts.
The only downside is that the money isn’t available penalty free until age 65. That’s a full 5.5 years after 401(k) or IRA funds are available.
Put the money in now and let it grow tax-free before using it later.
The HSA as an emergency fund
There are additional options for the HSA, once qualified medical expenses have been incurred. It becomes a nice supplement to emergency fund savings.
Under my current plan, seeing a specialist requires a $50 co-pay. After paying, I am able to withdraw from the HSA to cover the cost. Because there is no time limit to when I can make that claim, it’s the same as having $50 in an emergency fund.
So long as the HSA investments don’t go completely south, this $50 is now available, tax-free, whenever needed.
As expenses pile up over the course of many years, delaying reimbursement will allow the money to grow until needed.
Bridging the gap to age 59.5 with an HSA
I recently wrote about bridging the gap from early retirement to age 59.5, the age at which one can tap into retirement accounts penalty-free.
The HSA becomes a great tool to help accomplish this.
If you’ve been racking up medical expenses over the years, postponing reimbursement, these funds are now available to help bridge that gap.
This could be a great vehicle for supplementing one’s income while keeping income tax liability to a minimum.
Drawing from an HSA could help keep your annual income stay below a desired tax bracket threshold.
Investing HSA funds
How the HSA is invested is dependent somewhat on its planned usage. Depositing funds for immediate reimbursement should forgo any investment whatsoever.
Beyond that, it really is dependent on the timeline. With a long timeline, the funds could be invested in the same fashion as a 401(k) or IRA.
If the funds might be needed within a shorter timeline, a more conservative approach should be taken.
I hope to not need what’s in our HSA for many years down the road, and have put 100% of the invested funds into Vanguard’s Total Stock Market Index (VTSAX). If history is any indication, we should see that grow over time.
Investments should align with your overall risk tolerance. I am not a financial adviser. This is not financial advice. What is right for me and my situation may not be right for you. Heck, this may not even be what’s right in my situation!
The HSA is the best tax-advantaged account available
Because of the tax advantages for the HSA, it might be the best account available. The down side is the annual contribution limit. Start making contributions early and avoid drawing from the account, and wind up with a nice chunk of change.
All tax free.
Thanks, Uncle Sam.