By Brian Bruggeman, CFP®
Among the myriad options available to investors preparing for retirement, I believe one that might otherwise fly under the radar deserves your undivided attention: the Health Savings Account (HSA). This type of account lets the owner set aside money on a pre-tax basis to pay for qualified medical expenses, but contributions can only be made if you have a high-deductible health plan (HDHP). The minimum deductible for an HDHP in 2020 is $1,400 for an individual and $2,800 for a family.
HSAs have risen in popularity in recent years because health insurance costs continue to climb. Since HDHPs require employees to bear more of the deductible burden, more employers have begun to offer them, along with the complementary option of HSAs.
HSAs – Triple Tax-Advantaged
The HSA has great appeal for many reasons, primarily because it is triple tax-advantaged, combining the benefits of a traditional IRA and a Roth IRA. In fact, Morningstar refers to it as “the most tax-advantaged savings vehicle in the tax code.” With an HSA, you can pay current medical expenses and receive a deduction for them, while certain distributions are also tax-free and growth in the account is tax-deferred.
Additionally, unlike with other retirement accounts, you don’t have to pay the FICA tax for contributions through payroll. An HSA can also be used to address any qualified health expenses incurred while the account is open, at any time. Essentially, you pay medical expenses out-of-pocket and can then invest those funds for as long as you like.
For example, let’s say an individual had an HSA for the last 10 years and paid all of their qualified health care expenses out of pocket. Over that time, they made contributions of $50,000 to their HSA and incurred $22,000 of qualified medical expenses. Whenever that individual wants to, they can simply take a distribution for the $22,000 and not be subject to tax. Additionally, once they reach age 65, distributions from the HSA that are not used for health care expenses are taxed as ordinary income, similar to IRA distributions.
The recently enacted CARES Act has also expanded the definition of what qualifies as an eligible health care expense, providing investors with greater options to enhance their retirement savings. Items such as medical supplies and over-the-counter medications are now allowed, in addition to previously approved categories like physician visits, hospital services and prescriptions.
With so many clear benefits to HSAs, I’d also like to convey a note of caution. When people first hear about all that an HSA can offer, they might be tempted to choose a health plan based solely on whether an HSA option is provided. I don’t believe that’s an advisable approach, and would recommend evaluating the entirety of a health plan to determine whether it best fits your needs. But if that holistic assessment leads you to select a plan offering an HSA, then certainly take full advantage of it.
I recently compared the HSA option provided by my company with the non-HSA plan and modeled five different usage scenarios. These ranged from having no health care expenses to low, medium, high and catastrophic health care utilization. In each scenario, crunching the numbers proved that the HSA option made more financial sense for my family and I than the non-HSA plan. An HDHP and HSA could represent the most sensible choice for you as well, but it’s key to have enough current cash flow to accommodate out-of-pocket payments for higher copays and deductibles.
HSAs vs. FSAs
Another important point to mention is that an HSA is not the same as an FSA, though there are similarities between them and the acronyms can certainly cause confusion. HSAs were introduced in 2003 so individuals with high-deductible health plans could receive tax-preferred treatment of money meant for medical expenses. FSAs were created in the 1970s to let employees pay pre-tax dollars for medical and dependent care expenses not covered by an employer-sponsored health plan.
As with an HSA, an FSA can be funded via tax-free contributions. But the amount that you’d like an employer to deduct from your gross pay to fund an FSA must be declared for a given tax year, and you can lose any of this money that goes unused by the annual deadline. Generally speaking, I believe HSAs tend to provide greater benefits to more people than FSAs do.
When it comes to HSAs, my clients often ask about the limits involved and how they interact. Although these numbers can change annually, the current limit is roughly $3,400 each year for an individual and $6,800 for a family. It’s notable that an HSA can be used to address the health care expenses of a family member even if that person doesn’t contribute to the plan. For example, let’s say a husband has an HSA but his wife doesn’t. In that case, he could only contribute the individual amount but still utilize those funds to pay for the expenses of his wife.
The last point I’d like to make is that different HSAs can offer varied structures. Depending on your company’s health plan choices, the HSA available to you might not provide investment options. If you would prefer to receive a deduction and spend the money immediately, that’s not necessarily an issue. But if you’d rather invest these funds, it might make sense to look into your ability to transfer money from a company-provided HSA to another HSA. In fact, Morningstar offers a helpful ranking of the top HSAs for investing.
It all comes down to educating yourself, not only on what HSAs can offer generally, but about what different types of HSAs specifically provide. The internet features a variety of resources to assist in this endeavor, and consulting an expert financial advisor could also be a good option for you. Whatever method you choose, HSAs are too good an investment option to let pass by without careful evaluation.
About the author: Brian Bruggeman
Brian Bruggeman, CFP®, CTFA, is vice president and director of financial planning at Baker Boyer in Walla Walla, Washington. He has over 10 years of experience in financial services and expertise in estate planning, individual income tax, behavioral finance, portfolio construction, retirement planning, financial technology and financial industry practice management. Brian works with high-net-worth and ultra-high-net-worth individuals, high-earning young professionals and business owners. Throughout his career, Brian has focused on helping clients remain confident as they work through complex financial decisions.