The Hidden Potential of HSAs
Summary
Triple-tax advantaged: The tax advantages of health savings accounts (HSAs) are well-known by many. Contributions are made with pre-tax dollars, assets grow tax-deferred, and withdrawals for qualified expenses are tax-free.
Other benefits: HSA reimbursements for qualified medical expenses can be made at any time, now or years from now, potentially allowing for years of tax-free growth. Penalties for non-qualified expenses disappear once the account owner turns 65 years old, although taxes on those withdrawals will likely apply.
Avoid the cash trap: Barely 1 in 10 HSAs is invested in something other than cash. Review HSA contributions and accounts regularly to make sure they are allocated the way you intended.
Most of us are aware of the basic qualifications to contribute to an HSA. We discussed this here last year. And most of us have heard that HSAs can be triple-tax free:
Contributions can be made with pre-tax dollars, and employer contributions may be excluded from your income
Assets grow tax-deferred
Withdrawals for qualified medical expenses are tax-free
That alone should sound appealing for high income families who fall in one of the higher tax brackets.
Beyond the typical benefits of HSAs, here are two other benefits that may not be as well known.
Buy now, pay later
HSA distributions can be received tax-free for any qualified medical expenses incurred after the HSA was established at any time. Want to leave your HSA assets alone to grow tax-deferred for the next decade, then reimburse yourself from the HSA? Can do.
An example may help. Assume I have an HSA with a $5,000 balance and my family has $5,000 in qualified medical expenses this year. If I want to reimburse myself for those expenses from my HSA, I can choose to do that now or later. Let’s say I pay $5,000 out of pocket today to cover those expenses, leaving the $5,000 in the HSA. After a decade, if those assets are invested and earn 7% per year, the HSA would be worth about $9,800. I can then reimburse myself tax-free from the HSA, leaving $4,800 in the account to continue growing. I would just need to keep records that show:
Distributions were for qualified medical expenses
Those expenses had not previously been paid or reimbursed from another source
Those expenses had not been taken as an itemized deduction
If your family can afford to cover today’s medical expenses with other assets or current income, the HSA has the potential to become even more powerful over time.
Another retirement income option
We already mentioned the potential benefit of tax-free withdrawals for qualified medical expenses. But what if you need the HSA money for something else?
Distributions not used for qualified medical expenses are subject to a 20% additional tax, except if the distributions are taken after age 65. At that point, only ordinary income tax applies. To me, that sounds pretty similar to distributions from a traditional IRA or 401(k).
This begs another question. Which account should be prioritized when decided how to save for the future – HSA or 401(k)? If you participate in an employer sponsored retirement plan like a 401(k) and your company matches some of your contributions, that is as close to a no-brainer as we get. Take the free money. Contribute enough in your company’s plan to get the maximum company match. After that, I think there are two situations where the 401(k) has an edge:
You will retire early. Workers who separate from their company can access 401(k) assets as early as age 55 without incurring additional penalties. For IRAs, the age is 59.5, and for HSAs, we just mentioned the age is 65.
You know you will need the money before age 65. We just mentioned HSA distributions for non-qualified medical expenses are subject to an additional 20% tax. That’s a hefty penalty. If your company plan allows for withdrawals, those assets be accessed as early as age 59.5 without penalty. Of course, taxes would still apply, just not additional tax penalties.
Those are not the only decision points.
Traditional IRAs and employer plans will be subject to required minimum distributions (RMDs). HSAs are not. Perhaps the investment options are substantially better in the 401(k), or vice versa. Some HSAs can be linked to brokerage accounts, giving investors the freedom to invest HSA dollars in a huge list of choices like stocks, bonds, mutual funds, or ETFs. Employer sponsored plans can have similar brokerage windows, allowing for a huge number of investment choices beyond the standard offerings.
Ideally, having access to both buckets - the HSA and a 401(k) or IRA - can offer a lot of flexibility when supporting retirement and health care needs.
Avoid the cash trap!
Only 13% of HSA balances are invested in something other than cash! Would you fund a Roth IRA and leave it in cash? I hope not, and the HSA is no different. Tax-deferred growth and the potential for tax-free withdrawals are two of the biggest long-term benefits, and 87% of people are missing out on them. These individuals are (or were) enrolled in a high deductible health plan, so they likely paid more out-of-pocket for current medical expenses than if they had been on another plan. They set up an HSA. They went to the trouble of funding it. And they left it in cash.
Imagine making family HSA contributions each year for a decade. To keep the math simple, assume the family limit each year is $8,000. Left in cash and assuming cash earns 0%, your HSA will have $80,000 in it at the end of 10 years. On the other hand, if invested and earning 7% per year, that same HSA could have an additional $30,000 in assets. What if you fund an HSA for 20 years? The HSA earning 7% per year would have $168,000 more than the HSA left in cash.
HSAs can be great tools to help families save for future medical expenses – or retirement expenses more generally – in a tax-friendly way. Like most other account types, they have cons that should be weighed against the pros.
Let us know if you would like to discuss more.
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