I have a slightly embarrassing confession to make. I’ve had a Health Savings Account (HSA) for over three years now, but I just recently discovered how useful it can be as a retirement and investment vehicle.
A few years ago, when it came time to enroll in my employer’s health care plan, I basically said, “Just give me the plan with the lowest monthly premiums.”
The lowest priced plan happened to be a high-deductible health insurance plan. The enrollment coordinator explained that a HDHP often makes sense for young, single individuals who are in good health and don’t have any children.
The plan also featured an HSA and monthly employer contribution of $25. Choosing the plan that had the lowest monthly premiums and $300 in employer contributions each year was an easy decision.
Are You Making the Most of Your HSA?
I wish someone had told me exactly how it worked and what I could do to maximize my HSA.
Unfortunately, when I enrolled in my employer’s health care plan, nobody told me about the tax benefits, the contribution limits, or the opportunity to invest those contributions and grow them tax-free until I retire. I should’ve known better and done my homework, but sometimes you just don’t know what you don’t know.
Maybe you can relate. Maybe the only reason you have an HSA is because it happened to be paired with the most affordable plan you could find. You were probably aware of the tax benefits associated with using an HSA to pay for medical costs, but maybe you didn’t know how to use your HSA to boost your retirement savings.
Let me save you some time. Here’s exactly what you need to know to start making the most of your HSA.
What is an HSA?
An HSA is a tax-advantaged medical savings account that is only available to individuals who are enrolled in a high-deductible health insurance plan (HDHP). HSAs are intended to encourage individuals to save for future health care expenses by offering several useful tax benefits (discussed below).
The most well-known benefit is that your HSA contributions are deducted from your paycheck before income taxes are calculated on your wages. In other words, that money isn’t subject to federal income tax at the time it’s deposited into your account.
HSAs are often compared to Flexible Spending Accounts (FSAs), because they both offer ways to reduce income taxes by paying for medical expenses with pre-tax money. In many ways, they are similar. However, HSAs differ from FSAs because they don’t have the “use it or lose it” requirement. That means HSA contributions can roll over year after year, rather than being forfeited.
That is an important distinction because it gives rise to what I consider the most exciting benefit, the one I was completely unaware of: you can use your HSA as an investment account to grow your contributions tax-free!
What are the Tax Advantages?
HSAs are often referred to as “triple tax advantage” accounts, because of the three distinct tax benefits they offer. You’ll want to pay close attention to the following potential tax benefits that come with an HSA so you can optimize your HSA strategy:
- Money is Deposited Pre-Tax
As I mentioned above, the money you (or your employer) deposit into the account is pre-tax. Every dollar you contribute to your HSA reduces your taxable income. Plus, if you contribute to your HSA via payroll deductions, you’ll completely avoid paying FICA taxes on that income. (To my knowledge, this is the only way to avoid FICA taxes on your income.)
- Contributions Used for Qualified Medical Expenses aren’t Taxed
You can use HSA funds to pay for qualified medical expenses at any time without incurring any penalties or federal tax liability. In most cases, you’ll receive a debit card that you can use to pay for qualified expenses such as deductibles, copay, and monthly prescription costs.
- Investment Gains are Tax-Deferred
Similar to an IRA or 401(k), your HSA funds can grow tax-free while they’re in your account. An HSA is a powerful investment vehicle that can come in handy if you’ve already maxed out your IRA and 401(k). Add an HSA to the mix and you can increase your tax-advantaged retirement savings by $3,400 each year. Once you turn 65, any contributions you don’t use for health care costs can be withdrawn for any reason, subject to regular income taxes.
Retiring can cause a financial strain for you, especially if you have medical bills or other financial concerns. If you own your own home, the solution may surround you, literally. You can use the value of the home itself to borrow money through a reverse mortgage. It is called a reverse loan because it will allow you to collect money monthly instead of having to pay it back to your lender, as you would if you obtained a standard home loan. Through a reverse mortgage calculator, the amount you can borrow can be easily determined and doled out. By agreeing to stay in your home and pay for taxes and other responsibilities associated with ownership, you can delay the need to repay a reverse loan. However, when you leave the property, the total you owe must be repaid to the lender.
Contributing to Your HSA
I prefer to contribute to my HSA via payroll deductions. This method ensures I won’t pay FICA taxes on those contributions. If you choose to make contributions manually, you’ll be contributing post-tax money and end up missing out on the FICA tax savings. You can still deduct your contributions and reduce your taxable income when you file your taxes, but you won’t be able to recoup those FICA taxes.
If you’re fortunate enough to have an employer that contributes money to your HSA, make sure you take full advantage of that offer. That’s free money!
Keep in mind, HSA contribution limits aren’t the same as 401(k) contributions where employer contributions don’t count toward your annual limit. HSA contribution limits include both your contributions and your employer’s.
For 2017, HSA contribution limits for individuals are capped at $3,400. (The limit increases in 2018 to $3,450.) So, for example, if your employer contributes $400 to your HSA, your contributions are capped at $3,000.
How to Invest with Your HSA
In my opinion, the most enticing aspect of an HSA is the ability to invest and grow HSA contributions tax-free! Once you turn 65, you can withdraw your HSA funds and they are treated as regular taxable income (this is the same way traditional IRA withdrawals are treated). Getting started might take a little work, but it isn’t too complicated. There are just a few things I recommend considering as you get started:
- Which HSA Provider will you use?
Most people are accustomed to employer 401(k) plans where you have to use the 401(k) provider that your employer selects and your contributions must be made via payroll deductions. HSAs are different; you can use the HSA provider your employer has chosen or you can select your own.
Whether you go choose another HSA provider will most likely depend on whether your employer contributes to your HSA and the types of investment options available to you with that provider.
It’s worth noting, there are hundreds of HSA plans out there and they aren’t all created equal. In June 2017, Morningstar published an extensive report that evaluated ten of the nation’s largest HSA providers (the report is free to access but requires you to complete a contact form). In their report, Morningstar identified just one provider, the HSA Authority, as an HSA provider that was “compelling for use as a spending vehicle and an investment vehicle.”
If you are thinking about selecting your own HSA provider, I recommend reviewing that report to get a sense of the HSA provider landscape and the different factors (e.g., administrative fees and investment menu options) you should consider before making your decision.
What Investment Options are available to you?
If you plan on using an HSA as an investment vehicle you’ll definitely want to take a close look at the investment options your HSA provider offers. In general, I look for low-cost index funds. Unfortunately, these types of funds aren’t available with every HSA plan.
If your employer’s preferred HSA provider offers awful investment options, you might consider selecting your own HSA provider and contributing separately. Make sure you run the numbers to determine whether this is worth it, because you’ll be forfeiting 7.65% in FICA tax savings and might even end up paying duplicative administrative fees.
- Is there a Minimum Balance required before investing?
One downside to most HSAs is that you’re required to maintain a minimum available balance before investing your contributions. The minimum is usually somewhere between $1,000 and $2,000. This is unfortunate because HSA cash typically doesn’t earn interest. Therefore, the average person will spend a considerable amount of time building up their HSA savings before they can start investing and growing their contributions.
To avoid that scenario, you might consider making a few larger contributions so you can you’re your minimum balance requirement and start investing. The sooner you can start investing your HSA contributions, the sooner you can grow your portfolio and minimize the portion of your portfolio that’s forced to sit on the investing sidelines.
A Few Final Thoughts
It’s important that you do your research before you selecting a health insurance plan. If you get it wrong, you might end up paying more money for a health insurance plan that provides more coverage than you really need. On top of that, you might miss out on an opportunity to contribute pre-tax money to an HSA and boost your retirement investments.
Unfortunately, in most cases, you can only change your health insurance during open enrollment. Making the wrong selection initially could mean you’ll have to wait months before you can initiate the change. So make sure you do your homework and get it right on your first try!
If you determine that a high-deductible health insurance plan and an HSA are right for you, take some time to make sure you understand the potential tax benefits that come with that account. Gaining a thorough understanding of your HSA will help you manage your out-of-pocket medical expenses and potentially boost your retirement savings by tens or hundreds of thousands of dollars!