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How Good are Health Savings Accounts (HSA)?

February 07, 2022

Health Savings Accounts (HSA) are one of the most tax-efficient savings vehicles available. HSAs are often underestimated as a tax benefit, especially for highly compensated professionals. Additionally, HSAs might be the most flexible tax-advantaged account available. Let’s take a closer look:

What is a Health Savings Account?

Health Savings Accounts are a component to a high deductible health insurance plan, and an HSA is designed to pay for out-of-pocket medical expenses in a truly tax advantaged manner. A High Deductible Health Insurance Plan (HDHP) often offers cheaper premiums than normal health insurance plans since these health insurance plans have a higher deductible; when a HDHP is elected, a Health Savings Account (HSA) becomes available, where the owner of the HSA can open and fund the account. In some cases, the employer might even fund an HSA for the employees in exchange for the lower health insurance premium.

Funding an HSA is a lot like funding an IRA. Like an IRA, contributions into an HSA result in a tax deferral of earned income (or lowers taxable income for the year by the amount deposited in the HSA), and the proceeds can be invested. As the underlying investments grow, the growth inside the HSA is also taxed deferred.

The HSA can be used to make qualified health expenses. When the HSA is used correctly, the payments for health expenses are tax-free. As a quick recap, funding the HSA is tax deductible, and using the proceeds properly is tax-free. I think it’s fair to say that HSAs are tax-advantaged accounts.

2022 HSA Contribution Limits:

For tax-year 2022, the contribution limit is $3,650 for individuals and $7,300 for families. If you’re 55 or older, an additional $1,000 “catch-up” contribution can be made to the HSA. These contributions do not offset with retirement plan limitations, and there are no income limitations associated with HSA contributions, so funding 401(k)s and 403(b)s are not a conflict in funding an HSA. For those who have access to a Flexible Spending Account (FSA), you can fund both an HSA and an FSA simultaneously if you know you’ll have a lot of medical expenses in the year. If you fund an HSA and take a nonqualified distribution (request funds from the HSA not used for approved healthcare costs) before age 65, you’ll owe taxes plus a 20% penalty, so make sure the distributions are qualified or made after turning 65.

Where it Gets Really Good:

Aside from funding an HSA and paying health expenses on a tax-free basis, HSAs have some additional benefits. Any leftover funds in an HSA are carried over to the next year, and the funds stay invested until utilized. At age 65, an HSA can be used for anything without penalty. If the proceeds of an HSA are used for income in retirement, the funds are taxable as income, but there is no penalty. The HSA can essentially become another retirement account, but this retirement account does not have any Required Minimum Distribution rules. Even after 65, if the funds are used to pay for approved healthcare expenses, the proceeds are still income tax free.

Often, HSAs are funded as a salary deferral vehicle alongside traditional retirement plans and saved until a later date. If you don’t need reimbursement from the HSA and you can pay for medical care truly out-of-pocket with a checking account, that might be a good plan. There is no expiration on a tax-free reimbursement for medical expenses if a receipt for care is submitted, as long as the HSA existed when the medical expense was billed.

Here’s an example: if I had a medical procedure several years ago, and although I had an HSA, I didn’t claim my expenses of the procedure at the time. Year after year I kept funding the HSA, and the account grew from market appreciation plus contributions. If I go to start a new business, and I needed some funding, I could submit my medical receipts any time and get a tax-free reimbursement.

There is no timeline to submit a claim if you have the receipt to show that a qualified expense was paid, and the HSA was available during that year. You can even show receipts from the past to get tax-free reimbursements during retirement! Currently there is no timeline or expiration to submit expenses, so delaying healthcare expenses could result in tax-free income later if you keep receipts!

Health Savings Accounts are available with High Deductible Health Insurance plans to help pay for out-of-pocket expenses before the deductible is met. If the original purpose of an HSA is not used entirely, an HSA can be repurposed as a retirement account with additional benefits normal retirement plans don't offer. HSAs aren’t perfect, by any means, but they are versatile accounts that can potentially serve multiple purposes and account for changing goals in a financial plan.