Is an HSA Worth the Hype?
This article originally appeared in Aldrich Community, a client experience offering from Aldrich Wealth.
When thinking of investment vehicles for retirement, the Health Savings Account (HSA) probably isn’t top of mind. After all, those are just for medical expenses, right? Not so. Contrary to what the name would suggest, HSA funds are not limited to healthcare costs and, in fact, can provide substantial tax-advantaged investment opportunities.
A newlywed couple recently sat down with us to discuss whether to stop HSA contributions. They’d both historically maxed out their HSA accounts to protect against major medical expenses under their high-deductible health plans, and they were concerned about overfunding the accounts given their good health. They were surprised to learn that their savings could be accessed for retirement spending if there were no near-term medical needs and that the savings could be invested to help the balances grow.
As high-deductible health plans and HSAs become more prominent and accessible, we’d like to share some lesser-known ways that HSAs can benefit you beyond covering medical expenses.
- HSAs are “triple tax free”, making them one of the most tax-efficient vehicles for investors who have access to this type of plan. Contributions are tax-deductible, growth is tax-deferred, and withdrawals are tax-free for qualified expenses at any age.
- You can make withdrawals at any time for any purpose at ordinary income rates, subject to age restrictions.
- Reimbursements for qualified expenses can be timed to achieve greater growth and allow for larger, tax-free withdrawals down the road.
Whether or not you qualify for an HSA plan will depend on the healthcare coverage options available to you. Additionally, even with great incentives, whether an HSA is right for you depends on the medical needs of you and your covered family members. Your Aldrich advisors will gladly help you evaluate the pros and cons of utilizing an HSA and help provide you with the proper information to make the decision that works best for your family.
Tax Benefits
As noted above, the HSA is triple tax free. You might be asking yourself, “How are HSAs more tax-efficient than other retirement contributions I make?” Below, we compare each of the three tax-free components of an HSA to the traditional 401(k) to see how the account types stack up from a tax perspective.
- HSAs provide an income tax deduction on the amount you contribute, up to the contribution limit as you’d see with a 401(k).
a. Unlike 401(k) contributions, HSA contributions avoid FICA taxes, allowing your contributions to go further for you. - HSA funds can be invested just like 401(k) funds. In both cases, any growth from investments is tax-deferred.
- HSA withdrawals for qualified expenses are tax-free regardless of your age. With a 401(k), all withdrawals are taxable at ordinary income rates without exception. Plus, 401(k) withdrawals prior to 59.5 are subject to an additional 10% penalty even for unreimbursed medical bills unless they exceed 10% of adjusted gross income.
Uses in Retirement
You may be more familiar with older medical savings plans such as the Flexible Spending Account (FSA) where contributions were “use it or lose it”. With an HSA, your funds continue accruing if you don’t use them annually. Plus, you can still access your funds in retirement even if you have very few medical expenses.
Once you meet the 59.5 age requirement, you can make withdrawals at any time for any purpose. If the withdrawal is not for a qualified expense, you’ll just pay ordinary income tax on the distribution. This is the same tax rate you’d pay on a 401(k) withdrawal, except you’ll be better off withdrawing from your HSA since contributions weren’t subjected to FICA tax. However, it’s worth mentioning that non-qualified withdrawals made prior to age 59.5 are subject to a 20% penalty in addition to ordinary income tax.
If you’re retired and enrolled in Medicare, you also have the option to pay Medicare premiums or long-term care costs out of your HSA tax free! This can be a huge benefit given the rising cost of healthcare.
Spending Strategy
Generally speaking, one of the few downsides about tax-advantaged vehicles are the contribution limits imposed on them. The HSA is no exception, boasting some of the lowest contribution ceilings for account owners. That said, there are ways to overcome the hindrance of contribution limits on the account value over time if you have the financial flexibility to pay medical costs out of pocket today.
As noted above, withdrawals are only tax-free to the extent that they are for qualified medical expenses. However, there is currently no stipulation on when you must withdraw the funds for a given expense. How does this benefit you? The longer money is invested, the higher the potential to generate returns. If there’s no time limit for reimbursing a medical expense, you can let your HSA balance grow and then make tax-free withdrawals on the higher balance.
For example, let’s say our newlyweds have monthly prescription costs and regular doctor visits. They also have unplanned expenses like hospital stays for the births of their children. Instead of using HSA funds, they pay out of pocket with after-tax money and save their receipts. They continue this strategy for 30 years, all the while leaving the HSA account to grow. Assuming they have receipts for all qualified expenses, they can withdraw the lump-sum amount tax-free when needed whereas they’d incur capital gains or ordinary income taxes if they pulled funds from other account types.
Appendix
