The Ultimate Primer on Health Savings Accounts

Dana Anspach of Sensible Money explains in this Q&A with Retirement Daily editor Robert Powell what a health savings account is, how to use an HSA, when to begin drawing down the money in an HSA, and how to invest the money in an HSA.
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Retirement Daily: What is an HSA and can everyone have one?

Dana Anspach: An HSA is a health savings account. It is similar to an IRA in that you get a tax deduction for the amount you put in. But it is better than IRA because you can grow the funds tax-free and take tax-free withdrawals when the money is used for a qualified health care expense. Sometimes I hear them called triple-tax free.

With an IRA, you must have earned income to be eligible to contribute. This is not the case with an HSA. However, to be eligible to fund an HSA, you must have a qualified high-deductible health insurance plan. Your insurance plan will be able to tell you if the plan is HSA eligible.

HSAs offer more tax perks than any other plan -- the primary downside is you can't put a lot in. The maximum contribution limits in 2021 are $3,600 for those age 54 and younger. An extra $1,000 catch-up contribution is allowed for those age 55 and older. If you have a family plan, you can contribute both regular contribution amounts to your HSA, but if your spouse is also age 55 or older, in order to make the $1,000 catch-up contribution for your spouse, that must be put in their own separate HSA.

Retirement Daily: They sound great. Why don't more people use them? Wouldn't you fund an HSA forever?

Dana Anspach: Well, first off, not everyone has a high-deductible plan. But there are many people who do have an HSA plan and still don't take advantage of funding their HSA. I think some people think the funds are "use-it-or-lose-it" like the flexible spending accounts. But that is not the case with an HSA - you can let the funds accumulate for years and use them later. If you leave your employer or change plans, the funds are yours and remain in your HSA until you use them.

You can only contribute to HSAs up until you enroll in Medicare. For most people that means no more contributions once they reach age 65. In the year you turn 65 you can prorate your contribution based on how many months you were eligible. If you are in a situation where you do not have to enroll in Medicare at 65, then you can continue funding the HSA until you do enroll in Medicare.

Retirement Daily: How would you typically use an HSA?

Dana Anspach: What most people do is fund them, and then use them throughout the year to cover co-pays or deductibles or to cover other qualified items like dental expenses.

But that is not the only way to use them. You can invest the funds in an HSA and let the money grow tax-free for years.

At age 65, you can take penalty-free distributions from an HSA for any reason. The distributions will also be tax-free when used for qualified health care expenses. For example, you can use it to pay for any portion of Medicare, and for premiums for Medicare supplement or Medigap policies, or for long-term care insurance premiums. And if your Medicare Part B premium is automatically deducted from your Social Security check, you can simply reimburse yourself from your HSA.

So one option is to fund your HSA each year, not use it, and let it grow to be used tax-free to cover health premiums in retirement. This can be a very effective way to get years of tax-free gains.

HSA funds can also be used to cover health care premiums when you are unemployed, so you can let the funds accumulate as a special purpose emergency fund to cover health premiums if you're out of work.

There is even a backdoor way to use your HSA as an emergency fund for many items. You can withdraw tax-free from an HSA to cover eligible expenses you paid in previous years, as long the expense occurred after you established the HSA, you have the receipts, and you did not take this expense as an itemized deduction in a previous year.

The key is to fund it and save receipts for qualified health care expenses that you pay out of pocket. Example. I get a crown this year. It costs $1,000. I pay for it out of pocket. I save my receipt. I continue funding my HSA and let it grow. Three years later, I become unemployed. I can start using my HSA funds to cover my health insurance premiums AND can withdraw $1,000 for the crown from three years prior - and use that $1,000 for anything I need it for.

Retirement Daily: At what age do you recommend clients begin drawing down HSAs?

Dana Anspach: There isn't an ideal age, but they aren't the most efficient type of account to pass along to heirs so you would prioritize HSA withdrawals over withdrawing extra from Roth IRAs or traditional IRAs.

Let me qualify that by saying if your beneficiary is your spouse, it's great; it becomes their HSA. If you have a non-spouse beneficiary, the account becomes taxable in the year of your death, although your beneficiary does get to reduce the taxable amount by any qualified medical expenses paid on behalf of the decedent within one year after the date of death.

When you put all this together, in retirement, the best time to use the HSA would be during your highest tax rate years if it would lessen having to take additional IRA withdrawals or realizing cap gains.

If you are retired, and in a median to high tax rate, let's say 24% or higher, and have accumulated a large HSA balance, you may consider using it to cover your Medicare Supplement Plan and Medicare Part B premiums. For example, let's say you pay $300 a month or $3,600 a year. If that money had to come out of your IRA, after taxes you'd get $2,700 or less. By using the HSA, the funds can come out tax-free to cover this expense. You'd need a balance of about $100,000 to cover $3,600 a year for your probable life expectancy.

Retirement Daily: How should you invest the money in your HSA?

What I do is leave two years' worth of my deductible in what I call the low-volatility bucket and invest anything over that amount.

However, the way you invest should depend on how you plan on using the account. If you have a sufficient emergency fund outside of the HSA, and want your HSA to have years of accumulating tax-free growth, then you might invest it all more aggressively. This could make sense if you're confident you wouldn't need to take anything out of it at all for a minimum of five years, and hopefully for at least 10 years.

If you have a job where it is more likely you could go through bouts of unemployment, then you may want to keep your HSA in a stable option, like a savings account or money market. It won't grow much, but you also know it won't go down in value so if you need the funds next year to cover health insurance premiums, it will be there for you.

It's best to decide how you plan to use the account, and then invest according to that time frame. For me, I own my own business, so although unemployment isn't going to happen to me, like most business owners, my income can vary quite a bit from year to year, and I feel most comfortable keeping two years worth of deductible in savings within the HSA, knowing if the business goes through tough times, I could use that. Anything over that, I invest for growth and plan to let it accumulate for use in my retirement years.

I'll plan on starting to withdraw from my HSA likely in my mid-70s, once I'm receiving Social Security and taking my required minimum distributions. At that time, my balance should be large enough that at a minimum I could reimburse myself for my Medicare Part B premiums each year. In the meantime, I pay most of my health care expenses out of pocket and save receipts. so if for some reason I want or need to take a lump-sum distribution from my HSA, I'll be able to do so and it will be tax-free to the extent it is covering those items I previously paid.