How to Maximize the Triple Advantages of Health Savings Accounts

The most powerful savings and Retirement vehicle probably is the health savings account (HSA). Unfortunately, not enough people know about it or how to maximize its value.

HSAs were created only in 2003. They got off to a slow start but have been growing rapidly the last few years. Most people learn only about how to use them as an adjunct to their employer-provided health insurance to help pay out-of-pocket medical expenses. But a longer-term view maximizes their value.

You’re eligible to have contributions made to an HSA when your medical insurance is a high-deductible plan that is HSA-eligible. Not all high-deductible plans are HSA-eligible. Check with your insurer or employer to be sure your plan qualifies.

The maximum HSA contribution in 2020 for someone with individual coverage is $3,550, and it is $7,100 for someone with family coverage. There’s an addition-al $1,000 catch-up contribution allowed for those ages 55 and over. HSAs have rare triple tax benefits.

Contributions made by an individual to his or her account are deductible from gross income, and contributions made by an employer to the employee’s account are excluded from gross income. Many employers either make contributions to employee’s HSAs or match contributions made by employees up to a certain level. In addition, the account can be invested, and the earnings are tax free.

The third tax benefit is that distributions from the account are tax-free when used to pay for qualified medical expenses. A qualified medical expense is one that would be deductible as an itemized medical expense on your income tax return. See our January 2020 issue for details. So, unlike 401(k)s and traditional IRAs you aren’t simply deferring taxes.

With an HSA, the money goes into the account before taxes, can be invested tax-free and can be tax-free when it is distributed. You can use the HSA to help pay for medical expenses that aren’t covered by insurance, such as deductibles, copayments and noncovered items. I find a better strategy is to fully fund the HSA each year but pay current out-of-pocket medical expenses using after-tax dollars. Use the HSA as a retirement savings vehicle. Draw down the account only when you’re in retirement and medical expenses are increasing.

You can take the money out of the HSA tax-free. Compared to taking distributions from a traditional IRA or selling investments in a taxable account, using money from the HSA tax free reduces your retirement income taxes and avoids the stealth taxes, such as the tax on Social Security benefits and Medicare premium surtax. An HSA has no required minimum distributions, so you can let the account compound until you really need the money.

You can invest the annual HSA contributions to increase the account’s value. Some HSA custodians provide few investment options, generally offering only interest similar to that earned on CDs. But others link the HSA to broker-age accounts and allow you investment options similar to those of an IRA. That lets you invest for higher returns and increase the value of the HSA well above the amount of the contributions.

You can use the account to pay for or reimburse yourself for qualified medical expenses. You’ll need receipts for the expenses in case the IRS audits you or the HSA custodian raises questions.

Here’s a little-known use of HSAs. What many people don’t know is that there’s no closing date for receiving reimbursement of medical expenses. People are used to employer-provided flexible spending accounts in which they have to apply for reimbursements by the end of, or shortly after, the close of the calendar year.

There’s no such requirement with HSAs. You can accumulate receipts for years. In retirement, when you need money, you can be reimbursed for qualified expenses incurred in earlier years that weren’t reimbursed by insurance or the HSA. The advantage is that you can receive spending cash without having to take a taxable amount from your traditional IRA or investment accounts. That keeps you in a lower tax bracket and avoids or reduces the Medicare premium surtax.

An HSA is not a use-it-or-lose-it account. You name a beneficiary to inherit the account. Your spouse can inherit the HSA with the same tax-free status you had. A non-spouse beneficiary pays income tax on the account’s value on the date of your death. The non-spouse beneficiary, however, has up to a year after your death to reduce that tax by having the estate claim reimbursement for any unreimbursed lifetime medical bills of yours.

Because of the benefits of an HSA, it’s more important to fully fund an HSA before a 401(k) or other retirement account. Remember that HSA contributions aren’t allowed after you are enrolled in any part of Medicare. That means for most people, contributions stop at age 65.