In the hierarchy of tax-preferenced savings vehicles, the Health Savings Account (HSA) sits at the top. Unlike an IRA or 401K, an HSA offers a triple tax benefit: contributions to the account are tax-deductible, earnings grow tax-deferred and distributions are tax-free as long as they are used to pay for qualified health expenses. In contrast, IRAs and 401Ks only offer two of these three tax benefits, and tax-deferred annuities only offer one.
Yet, many people deplete their HSA accounts each year to pay for medical expenses. For high earners scrounging for tax benefits, this is a mistake. Here is what you need to know about HSAs.
Who Can Contribute?
In order to contribute to an HSA, you must participate in a high-deductible insurance plan. In 2019, a high-deductible plan is defined as a plan with at least a $1,350 deductible for an individual or $2,700 for a family.
What are the Contribution Limits?
In 2019, total contribution limits to an HSA are $3,500 for an individual and $7,000 for a family. Some employers actually offer HSAs to their employees and make contributions on the employees’ behalf. Employer contributions are included in the total contribution limit and they are not taxable to the employee. These contributions are in addition to any other tax-deferred contributions you or your employer may make to employer retirement plans and IRAs.
An HSA as an Investment Vehicle
Many people think of HSAs as a tax-efficient way to pay medical bills. However, unlike a Flexible Spending Account (“FSA”), an HSA does not have a “use it or lose it” provision. HSA funds can accumulate and be used in the future. Furthermore, most HSA providers allow account holders to invest HSA balances in mutual funds.
Therefore, high earners and investors seeking tax-efficient ways to save for retirement should not spend their HSA contributions each year, but instead should pay for medical expenses from other sources and use the HSA as a supplemental retirement account.
What if My HSA Provider Does Not Allow Investing?
Some people participate in an HSA through their employer and many employer plans do not permit investing. If that is the case, you can contribute to the account through your employer (get the payroll deduction and benefit from any employer contributions) and once per year, you can rollover your HSA to an institution that does allow investing (ex. Fidelity, HSA Bank, Optum Bank). If you leave your current employer and have an HSA with that company, you can roll it over to a new employer’s HSA or to your own – the balance belongs to you and is not forfeited.
What Happens When I Turn 65?
Once the account holder reaches age 65, funds can be withdrawn for non-medical expenses with no penalty, although distributions for non-medical needs will be taxed at ordinary income tax rates.
A Few Caveats to Be Aware of Regarding HSAs
Estate Planning and Creditor Protection
Unlike IRAs or other investment accounts which can provide estate planning benefits, HSAs should ideally be used during life. If an HSA in inherited by someone other than a spouse, the account must be liquidated in the year it is inherited and the entire balance is taxable to the beneficiary. Additionally, unlike IRAs and employer retirement plans, HSAs do not share the same creditor protection benefits.
HSAs and Medicare
Those who are on Medicare cannot contribute to an HSA, although they can use funds within an existing HSA as needed.
Withdrawals for Non-Medical Expenses
If funds are withdrawn from an HSA prior to age 65 for non-medical expenses, there is a 20% penalty.
Health Savings Accounts are attractive saving vehicles for many reasons, but they provide an exceptional savings opportunity for high earners who can allow account balances to accumulate over time. When developing an overall savings strategy, if you are eligible to participate in an HSA, contributions should be considered, along with participation in employer-sponsored retirement plans, IRAs and non-qualified accounts.