No matter how much you’re making each year or how much last year’s Christmas bonus was, odds are that retirement seems like an unattainable fantasy. While you might not have an HSA account, you regularly contribute to your company’s 401(k). But no matter how much you invest, your earnings always seems to be hit by the same roadblock: taxes.
But, what if there were a trick. What if there were an often-overlooked investment tool that could help you contribute to your retirement savings in AND lessen your tax burden. That’s where the HSA account comes in.
An HSA account is one of the only investment tools that is 100% tax-free. Not only is it tax-free, but it offers a triple-tax-advantage meaning that all the money that enters, grows and leaves is NEVER taxed.
So, all this talk about big savings, but what the heck is an HSA account and how do I get one? This article will walk you through the basics of an HSA, the benefits of an HSA, and any limitations to this type of investment.
But, let’s not get ahead of ourselves. First things first.
What is an HSA Account?
HSA stands for Health Savings Account and is a medical savings account available for those enrolled in a high deductible health plan (HDHP).
The IRS has defined an HDHP in 2019 as a health plan with a minimum deductible of $1,350 and maximum out-of-pocket expense limit of $6,750 each year.
For family coverage, the minimum deductible is $2,700 and maximum out-of-pocket is $13,500 each year.
HSAs can be very helpful by reserving a large fund of money to cover heavy medical expenses without having to dig into any personal or retirement savings.
HSAs were established to provide consumers with a financial tool that could cover high medical costs while bypassing any tax liabilities. Like other savings accounts, funds deposited into an HSA can be invested into a diversified portfolio of mutual funds, index funds, bonds, ETFs, etc where earnings roll over (or accumulate) year to year.
Unlike other savings or investment accounts, HSAs are completely tax-free (something we like to call triple-tax-advantaged), but there are specifications on how these funds can be used.
Funds in an HSA can be used at any time so long as they are used to pay for an eligible medical expense.
Okay, so this is great and all, but you might be wondering: what happens to my HSA if I need all the existing funds to pay for my medical expenses? While HSAs offer many benefits for medical costs, especially in the case of an unforeseen illness or catastrophe, what most people don’t realize are the secret benefits that HSAs can add to both your retirement savings and your annual tax contributions.
Secret Benefits of an HSA Account #1: Increased Retirement Savings
If you’ve read any of the recent Finance Twins articles, you’ve probably stumbled upon the famous Roth IRA, one of the best tools for retirement savings. While you might be an expert on this topic, what you might not yet know, is that an HSA is arguably the best tool for retirement savings, beating Roth IRAs and 401Ks by a landslide.
So, you might be thinking: But Roth IRAs can be withdrawn tax free, how could it get better than that? Well, the good news is that it can!
Unlike Roth IRAs, HSA contributions are not only exempt from the sneaky capital gains tax but are actually triple-tax-advantaged.
HSA Accounts Are Triple-Tax-Advantaged:
- First of all, HSA contributions are often made with PRE-TAX dollars, meaning you don’t have to pay taxes on the money deposited into your HSA. If, however, you decide to contribute to your HSA using AFTER-TAX dollars, this money will be deducted from your taxable income.One small lesson you may have learned from Accounting 101 (or from a 15-minute Crash Course on paying your taxes) is that lower taxable income = less taxes you owe the government!!!
- Secondly, in HSAs, earnings grow tax-free. This means that any and all growth in your HSA investments are exempt from additional taxes at the end of each year.
- And finally, the icing on the cake is that HSAs have tax-free withdrawal. Tax-free withdrawal means that any withdrawals from your HSA that are qualified medical expenses are exempt from taxes, as well.
However, it is important to note that withdrawing money from an HSA for consumption not eligible for HSA qualification when you are NOT 65+ will result in a withdrawal penalty.
The current withdrawal penalty for non-qualified expenses is 20%.
How does this help my retirement plan? For those aged 65+, there is no qualification for the use of withdraw funds. If you are 65+, you can withdraw funds from your HSA and use them on whatever the heck you want without owing an early withdrawal penalty. If you use the funds for a qualified medical expense you won't owe a penny to the government, but if you use the money to buy a new piece of furniture you'll pay income tax on the money. This means that in the best case scenario, you'll get the triple-tax advantage, and worst case you'll be no worse off than a traditional IRA!
Essentially, funds remaining in your HSA at this time become another retirement savings account.
In layman's terms, the money enters tax free, grows tax free AND ideally leaves tax free. It doesn’t get better than that.
Secret Benefits of an HSA Account #2: Reduced Annual Tax Contributions
Okay, so we’ve established that HSAs provide many financial benefits for medical expenses and retirement savings, but what if those aren’t the biggest concerns for you right now? Does an HSA still offer benefits for me aside from retirement and medical related expenses?
Even if those aren’t big concerns for you, HSAs still provide tremendous benefits that include reduced annual tax contributions.
Since HSAs are normally funded pre-tax, this lowers your taxable income and, therefore, lowers the amount of taxes you have to pay every year that you contribute to your HSA. However, Even if you contribute to your HSA with after-tax funds, these contributions will be deducted from your taxable income, also lowering your annual tax liability.
Basically, any HSA contribution will reduce your taxes!
Secret Benefits of an HSA Account #3: Employer Contributions
As if the tax savings weren’t enough, there’s another perk that may be even more powerful: employer contributions to your HSA!
That’s right folks, your employer can contribute directly to your HSA account. That’s free money going straight to your account, similar to a 401K retirement savings plan. How much employers contribute usually depends on the size of the company.
For employers with fewer than 500 employees, the average contribution for a single employee is $750 and $1,200 for an employee with a family plan.
For employers with more than 500 employees, the average contribution for a single employee is $500, and for employees with family, the average contribution is $1,000.
However, any contribution from an employer is deducted from the total HSA contribution limit for the year so that total HSA contributions do not exceed the limits.
HSA Account Limitations
This must be too good to be true. There has to be a catch, right? Like all things, there are limitations to a health savings account.
It’s important to be aware of these, but don’t let them scare you away from contributing to one of the best investment tools out there.
As mentioned previously, there is no penalty when withdrawing funds in an HSA if the funds:
- Are used for eligible medical purposes or
- Are withdrawn at or after age 65
However, withdrawals for non-qualified medical costs before you turn 65 are subject to income taxes and a 20% penalty.
If you don’t use a distribution from your HSA for qualified medical expenses, you must pay tax on it. Report the amount on IRS Form 8889 and file it with your tax Form 1040 or Form 1040NR. You may have to pay an additional 20% tax on your taxable distribution.
While I do not advise withdrawing prior to age 65 for non-medical reasons, it’s important to note that the high (and increasing!) cost of medical expenses make it likely that you'll have more than enough medical expenses to cover your HSA.
Additionally, there are limitations to the amount one can contribute to an HSA each year. The limits are lower than those for an IRA.
For individual coverage, the 2019 HSA contribution limit is $3,500/year, and the 2019 HSA contribution limit is $7,000/year for family coverage. Nonetheless, $3,500 every year adds up.
For example, contributing $3,500 each year at an average compound growth rate of 6% per year would grow to over $81,000 after only 15 years. To have a comparable amount in a Roth IRA, you would have had to contribute $106,579 if you were in a 24% tax bracket.
That means you get to keep more of your money instead of handing it over to Uncle Sam.
Should I Get an HSA Account?
As one of the most tax-efficient investment tools out there, HSAs can offer you many benefits; however, this investment tool may not always be the best option for everyone.
So, how do I know if I should get an HSA?
First things first, it is important that you meet the HSA qualifications.
HSA Account Qualifications:
- Not be enrolled in Medicare
- Not be a dependent on someone else’s tax return
- Must be enrolled in a HDHP on the first day of the month
As mentioned earlier, you must be enrolled in a HDHP to open an HSA. HDHPs offer immediate savings since these payment plans include lower monthly premiums.
However, you are required to pay a higher deductible (or initial out-of-pocket payment) before your medical coverage begins. Therefore, HDHPs are generally recommended for young individuals ages 20-45 who are healthy and don’t foresee major medical expenses.
A higher deductible means that the patient will need to pay the medical costs upfront before receiving health insurance benefits. Therefore, HDHPs are not for everyone since it can be difficult for some to pocket this money upfront and is generally not recommended for people with chronic health conditions.
However, if you do meet these HSA qualifications, then you should strongly consider opening one. The lower tax benefits can increase your retirement savings exponentially WITHOUT having to drastically change your current spending.
In short, HSAs can be a very useful tool. Opening an HSA could be the secret to your retirement plan or even the secret to lowering your taxes. However, it’s important, as with all financial decisions, to weigh the costs against benefits.
My recommendation is to first determine if enrolling in an HDHP is the best decision for you and your family. If so, then opening an HSA could be an easy next step to increase your retirement savings and reduce your annual tax contributions.
How To Use An HSA Account To Maximize Its Benefits
So you have an HSA and then go to the doctor and get hit with a $150 bill for the visit. You have the HSA which you can use to pay for it. But what if I told you to pay out of pocket with your credit card instead?
In order to maximize the amazing tax benefits of the HSA, leave the money invested in the account as long as possible so it can grow tax free. But you need to make sure that you save any medical receipts along the way. We have a guide if you are not sure how to start investing!
If you pay via credit card (ONLY do this if you are responsible with your credit and your card gets paid off IN FULL every month) you’ll also earn credit card points.
The HSA is the best retirement account that few people have heard of, and now you know why!
For more information on this topic, IRS Publication 969.
About The Author: Rachel Johannesen is an all-star and student at the Wharton School of the University of Pennsylvania.