The only way to get a triple-tax benefit
This is part three of a series on the different vehicles used to save and invest so your money is aligned with what you value. You can read Part One here.
Disclaimer:
This information is presented for educational purposes only and is not advice or a recommendation to act. This article includes opinions of the writer which should not be construed as fact.
In this article:
HSA rules
HSA strategies
How to open an HSA
The King of All [tax-advantaged accounts]
The IRS gives preferential treatment to certain account types to incentivize certain behavior. Health Savings Accounts (HSA) are one such account, designed to give average citizens like you and me a way to pay for medical expenses tax-free.
On other preferential accounts, such as Traditional IRAs, Roth IRAs, and 401(k)s, you would have to pay taxes on the contributions (Roth) or on the withdrawals (Traditional). HSAs are the only account type that offers a triple tax benefit.
“HSAs are the only account type that offers a triple tax benefit. 1) Tax-deductible contributions 2) Tax-free growth 3) Tax-free withdrawals”
HSAs allow you to make tax-deductible contributions, tax-free growth on money in the account, and tax-free withdrawals for qualified medical expenses. HSAs are similar to a Flexible Spending Account (FSA), but one of the biggest differences is HSA balances carry over from year-to-year, whereas an FSA is a “use it or lose it” model.
Eligibility requirements
These determine your eligibility to open and contribute to a plan. There are no requirements to maintain and withdraw from an account, so even if your circumstances change and you no longer meet these requirements, you can keep your account.
To be eligible for an HSA:
You must be covered under a high-deductible health plan (HDHP) on the first day of the month.
You have no other health coverage (see IRS Pub. 969 for details).
You aren’t enrolled in Medicare.
You can’t be claimed as a dependent on someone else’s tax return.
In general, if you are under 65 and covered under an HDHP, you can fund an HSA.
Contribution limits
Family coverage is you plus any dependent. The whole family need not be covered to get the higher contribution limit.
There is a limit to the amount of contributions you can make in a year, which changes each year with inflation. In 2024, if you have self-only coverage, your limit is $4,150. If you have family coverage, the limit is doubled, or $8,300.
When calculating your contribution limit, keep in mind that contributions from third parties (such as an employer) count toward your limit. This contrasts with a 401(k), where employer contributions are separate from employee contributions.
If you make an excess contribution, you must withdraw the excess plus any earnings prior to filing your tax return. If you do not, your excess is subject to a 6% excise tax (i.e. a penalty), payable every year until the excess is removed.
The limits above assume you are covered by an HDHP for the entire year. If you lose your HDHP coverage during the year (for example if you terminate employment), your contribution limit will be prorated by months. For example, if you have family coverage from January through July, your contribution limit will be 7/12 of $8,300, or $4,842.
HSA Strategies
The strategies below assume an HDHP with HSA is the most cost effective way for you to pay for healthcare.
An independent health insurance broker can help you evaluate the best coverage for your situation.
Conventional wisdom is that an HDHP is best for healthy people. If you have moderate health care needs, but not enough to take advantage of the HDHP’s lower max out-of-pocket limits (when compared to non-HDHP), you may want to consider getting on a non-HDHP with lower copays and deductibles.
Once you’ve determined an HDHP with HSA is right for you, the way you utilize an HSA depends on your financial situation – specifically, your disposable income.
Strategy 1 – Strict funding
Strategy 2 – Maximize contributions
Strategy 3 – Maximize contributions, pay expenses out of pocket
For many people, the best way to use an HSA is strictly to fund your medical expenses. Estimate the amount of qualified medical expenses you have each year, divide that number by 12, and contribute that amount to an HSA each month. When you incur a qualified expense (at the doctor or at the pharmacy), you can use the debit card provided by your HSA provider to pay for the expenses directly from your account.
Expenses incurred by your spouse and children can be qualified, even if they aren’t covered under your plan!
If you have enough income, you can choose to contribute the maximum amount allowable, regardless of medical expenses. You can pay your medical expenses out of the account, and what’s left at the end of the year is yours to keep for future expenses.
The BEST HSA strategy
If you can afford it, the best HSA strategy is to max your contribution to the HSA and to pay for your medical expenses out of pocket, taking nothing from the HSA. Why would you do that? Because the funds in the HSA grow tax-free, and you can withdraw in the future tax-free for qualified medical expenses, the more money you can leave in the HSA, the better.
Keeping receipts
Be sure to keep records of your qualified expenses. Generally, this includes three things: 1) itemized bill from the provider 2) Explanation of benefits from your insurer 3) a transaction receipt or cancelled check.
If you choose to pay your expenses out of pocket and not withdraw from the HSA, you should still keep the receipts in case you want to claim at a later date. Qualified expenses can be claimed any time after they occurred; it doesn’t necessarily have to be in the same year. This feels like a loophole, but as of 2024 is still allowable.
Investments in my HSA?
Most HSAs will have a default cash option, which may be FDIC-insured and will pay a small bit of interest. If you are going to pay your expenses with the HSA, you’ll probably want to keep your funds in this cash account.
However, if you are contributing more than your expenses, or if you are paying your expenses out of pocket, you may want to consider investing the funds in your HSA for a higher return.
The investment section of your HSA will look similar to a 401(k) or IRA. You should have a variety of options, from short-term cash or money market funds, to medium-term bond funds, to high-growth stock funds.
The type of investment you buy within the HSA depends on your personal situation. I don’t want to talk too much about investments in this piece, but my general advice would be don’t invest money in the stock market if you will need it in the next five years.
What if I don’t use it?
“At age 65, you can withdraw penalty-free for any reason.”
One of the biggest concerns people have with HSAs the question of “what if I save all this money for medical expenses I don’t have?”. First, congratulations! You must have worked hard or else have been very lucky to be so healthy your whole life. Further, there are ways to get money out of your account without penalty.
Nonqualified HSA withdrawals are subject to income tax and a 20% penalty. There are three exceptions to the 20% rule: death, disability, and reaching 65 years of age. For most people, age 65 is their first chance to receive penalty-free withdrawals.
When you reach age 65, your HSA functions essentially like an IRA (you pay ordinary income tax) for non-qualified withdrawals, and it retains the tax-free treatment on qualified expenses. (It’s worth noting, however, that an IRA can be tapped penalty-free 5 ½ years earlier, at age 59 ½. Still, the flexibility of an HSA makes it a compelling alternative to [or supplement of] a Traditional IRA or 401(k), when choosing where to save.)
Additionally, if you are 65+ and enrolled in Medicare, your monthly premiums are considered a qualified expense and are eligible for tax-free withdrawals.
How do I open an HSA?
HSAs must be opened with an IRS-approved custodian, which is typically a bank or other financial institution.
If you receive your HDHP coverage through your employer, ask HR if they recommend a certain custodian. When you use the recommended custodian, your employer can probably assist you in opening the account and setting up payroll deductions.
If your employer does not recommend one, or you have an HDHP through Marketplace, you will have to find your own custodian at a local bank or online. Before you open an account, make sure you understand the fees of the account. See whether they offer you a debit card and the option to invest your funds, if that’s something you want.
Once your account is open, you can make contributions either through payroll deductions or directly with the HSA custodian. If you make contributions directly, you’ll need to report them on your tax return to get the tax deduction. If you make contributions via payroll, ask if the amount of contributions was included in your W-2.
If you make contributions through a cafeteria plan via payroll, your employer will calculate your deduction on Form W-2. (Both employer and employee contributions are reported in Box 12 using Code W, and the contribution amount was subtracted from your gross income to calculate taxable income in Box 1.)
Bottom line
If you are covered by a High Deductible Health Plan (HDHP), using a Health Savings Account (HSA) can reduce your tax bill. Make sure this triple-tax advantaged account is included in your savings plan.
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