Health Savings Accounts (HSAs) are tax-deferred accounts for individuals or families who are covered under a "high deductible health plan". Unlike retirement accounts such as 401(k)s and IRAs, HSAs are a bank and investment account hybrid. There is a "bank" cash component and usually an investment option as well. In addition, HSAs play by similar contribution & distribution rules as retirement plans like IRAs and 401(k)s.
The real power of HSAs is in their tax benefits. Tax benefits can be broken down into three categories:
A tax deduction in any year contributions are made.
Tax deferral on dividends, interest, and capital gains.
Tax-free distributions for qualifying medical expenses.
Of all the various savings and investment account structures, no other account in the Internal Revenue Code provides the same trio of tax benefits!
There are two main use philosophies with HSAs. In this post I'll give you a framework to follow depending on your specific circumstances. I'll even share how I use my personal HSA. First, let's explore the basics.
To qualify for an HSA, you either need to be covered by a high deductible health plan at work or one you purchase on your own out on the open market. The first test you need to pass covers your health insurance policy's deductibles and out of pocket maximums. These are the 2020 thresholds:
Minimum deductible of at least $1,400 ($2,800 for family coverage).
Out of pocket maximum of no more than $6,900 ($13,800 for family).
Assuming your health insurance policy falls within those guidelines, the next question to ask is "Will I be covered under a non-high deductible health plan, such as Medicare Part A, for the entire year?". If no, then you can proceed. If yes, then you aren't eligible for an HSA. Essentially, you can't have two health insurance policies of which one isn't a high deductible plan and still contribute to an HSA.
The next test you must pass is that you cannot be covered as a "dependent" on someone else's tax return. Children, students, and aging parents that are cared for with financial support aren't eligible.
The final test you must pass involves the time exposure to a high deductible health plan. If you'll be covered by a high deductible health plan in December of the year you contribute to the HSA, then you can make your full contribution. If the answer is "no" due to a job or health insurance policy change, then you are only eligible to make a pro-rata contribution equivalent to the months you're actually covered by the high deductible health plan. For example, if you only own a high deductible health insurance policy that covers your family for 6 months out of the year, then your $7,100 contribution limit is reduced to $3,550 since you were only eligible for 50% of the year.
Assuming you make it through that gauntlet of tests, here are the 2020 HSA contribution limits:
$3,550 for individuals.
&7,100 for families.
If you're a seasoned investor over age 55, you get to make additional catch-up contributions in the amount of $1,000. So, you could conceivably get $8,100 into an HSA in 2020 if you have enough grey hairs.
Unlike retirement plans where you have to have "earned income" from a job or self-employed business in order to contribute, you don't actually have to work for a living to get money into an HSA. For retirees who retire prior to age 65 (when Medicare begins), HSAs represent a unique financial planning opportunity with sizable tax reduction benefits.
Contributions can often be made directly from your employer's payroll. Using an employee over age 55 with a high deductible health plan covering the entire family as an example, an HSA contribution of $8,100 results in $1,944 less in federal taxes assuming a 24% tax bracket. That's almost $20,000 in tax savings when applied over a 10-year time period.
If you're self-employed or using an HSA outside of what your employer recommends, you make contributions from your bank account. But, you receive a tax deduction based on the amount of the contribution. Same tax savings outcome as above, just a different way to arrive at it.
As long as HSA distributions are used for "qualified health expenditures", both the original contributions as well as any growth associated with those dollars come out tax-free. Qualifying for tax-free distributions is easy as the definition of "Qualified" is expansive. Here is a partial list of medical costs that count:
- Physician fees - Lab fees - Dental fees
- X-rays - Prescription drugs - Vision care
- Physical therapy - Chiropractic care - Fertility treatment
- Modifications to your home/vehicle, i.e., wheelchair ramp
- Christian science care (for real, I'm not kidding)
You can find the full list of qualifying medical expenses in IRS Publication 502 found HERE. Practically everything except health insurance premiums is covered.
Beware that HSA distributions not attributable to qualified medical expenses trigger both taxation at ordinary income rates as well as a 20% withdrawal penalty. However, the 20% penalty disappears once the HSA owner reaches age 65. After age 65, HSA distributions used for nonqualifying medical expenses receive the same tax treatment as an IRA, which still makes them a valuable account to have in a retirement income arsenal. Essentially, if you wanted to buy a car with HSA dollars, you can! You just pay taxes on the amount distributed, same as you would if the money came out of an IRA or 401(k) plan.
Unlike IRAs or 401(k) plans, HSAs aren't subject to IRS Required Minimum Distributions (RMDs). If this forced distribution mechanic is factored in, HSAs become a slightly better retirement income account than IRAs and 401(k) plans. The rationale is that the HSA owner maintains more control over the account compared to an IRA or 401(k) plan. In this case, more control = fewer taxes paid over the lifetime of the HSA owner.
TWO USE PHILOSOPHIES
Knowing that you can leave contributions in the HSA for as little as a day or as long as you wish, the fundamental question you must answer after your contribution has been made is will my contribution be taken out for medical expenses in the current year or will it remain in the account for future use?
Use It Now
This strategy accepts the idea that we're limiting the use of the HSA purely for the tax deduction. Using It Now works best for folks who 1. don't have much spare cash lying around 2. need to play catch up in their retirement account contributions 3. don't believe they'll incur future medical expenses 4. don't want to bother managing another long term account for a specific future expense.
This type of HSA user typically contributes an amount equal to annual qualifying medical expenses (within the contribution limits, of course!). The money goes in. Shortly after, it comes back out. Just make sure to request the distribution a week or so prior to the end of the year so the HSA bank has time to process the request so it counts for the year you want it to.
Use It Later
By delaying HSA distributions until a future date, you're essentially saying I don't need this money now and I want it to grow tax-deferred.
Even though HSAs are issued by banks, most HSA providers allow account owners to invest their contributions in mutual funds. We wouldn't leave our Roth IRA money in cash, and the same logic applies to HSAs.
The Use It Later philosophy works best for investors that 1. can pay for annual medical expenses out of current cash flow 2. are on track with retirement and college education savings 3. acknowledge that future medical expenses will take a substantial bite out of retirement savings. The Use It Later HSA user typically maxes out contributions to the plan.
THE BEST HSAs
Morningstar regularly publishes a report covering two key HSA considerations, how well various HSA providers function as a spending account and how well they function as investing accounts. The spending account rankings can be correlated with the Use It Now philosophy and the investment rankings relate to the Use It Later philosophy. You can read the full October 2019 analysis HERE.
Depending on which use category you best fall into, view the rankings as a guide for where to set up your HSA. If you already have an HSA associated with your employer and it didn't make either list, there's no reason why you can't open up your own HSA outside of your employer. The tax benefits are the same no matter where the contributions originate from.
Consider ditching your employer's HSA and opening your own if you meet the following three criteria:
Your health insurance plan conforms to the definition of "high deductible".
Your employer does not contribute to your employer-sponsored HSA.
Your current HSA is expensive and or a pain in the butt.
According to Morningstar, the best HSA is found at Fidelity. They came out on top in both the spending and investment categories. A Fidelity HSA can be opened HERE.
HOW I USE MY HSA
Years ago when I first opened my HSA, I didn't have a ton of free cash flow left over each month. I couldn't afford to put away my full contribution so I simply made a contribution at the beginning of December equal to that year's qualifying medical expenses. Once the money became available for withdrawal after a few days, I requested a distribution. I then used that distribution to fund accounts like my 401(k) plan. My HSA use was limited to the deduction.
Things have evolved since then, and now I can afford to leave my HSA contributions alone. Now I get the deduction and I have additional money in a tax-deferred retirement account that grows that I can tap down the road. You should choose whatever works best for your own cash flow and financial planning goals.
I never pay for my medical expenses with the debit card you get with an HSA. There's a common misconception promoted by HSA issuers that touts the ability to pay for medical expenses directly from the HSA as some kind of benefit. While I consider this a small simplicity benefit, it's not the most efficient way to pay for medical expenses. There's no rule that forces us to pay for qualified medical expenses directly from the HSA. Therefore, why not put the medical expenses on a credit card to earn reward points? I hope this goes without saying, but make sure you pay off the credit card in full at the end of the month!
As soon as I incur a qualifying medical expense, I update the spreadsheet I created specifically for HSA expense tracking. Then, I save the receipt in a designated folder in the cloud where I organize all my personal documents. I like to save my receipts in case I'm ever audited. As a general rule, you always want to save the "proof" driving any tax benefit you're claiming. Here's what my spreadsheet looks like.
Note that there are separate tabs for myself, my wife, and my kids. If you like, just email me and I'll send you a copy of the spreadsheet you can use yourself.
Around the beginning of February each year, I receive a tax form showing the prior year's HSA activity, including contributions and any distributions. This gets sent off to my tax advisor when I compile everything for my return.
WRAPPING IT UP
HSAs can be a great tool to take advantage of if you qualify. They are considered triple tax free; you receive a tax deduction based on contributions, interest, dividends, and capital gains within the HSA are all tax-deferred, and all distributions for qualifying medical expenses (at any age) come out tax free.
Determining eligibility and whether or not to use your employer-sponsored HSA can get complicated. HSAs are a bit messy, but they're worth it for the tax benefits. Plus, it's almost guaranteed that you'll incur medical expenses at some point in retirement. An HSA is a tax-savvy account to prepare for what's coming.
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