Background
Health savings accounts (HSAs) are triple tax-advantaged, having three combined purposes:
- Tax-deductible savings
- Tax-free earnings
- Tax-free withdrawals, if used for qualified medical expenses (QMEs); if you are disabled or 65 or older, withdrawals for any purpose are taxed at your current tax rate
HSAs allow you to set money aside for qualified medical expenses on a pre-tax basis. These accounts require high deductible health plan (HDHP) insurance and may be offered by your employer or opened directly through a health insurance provider or bank. These accounts have become increasingly popular, as they allow employees access to a tax-deferred means of saving money to pay for medical costs now and in retirement. HSAs are attractive to employers, too, by saving on company healthcare costs.
Advantages of Enrolling in an HSA
An HSA allows you to lower your overall health costs by using untaxed dollars to pay for deductibles, copayments, coinsurance, and other qualified medical expenses. Money in HSAs can grow, and you may be able to put this cash into a variety of investments, including mutual funds. HSAs are “portable,” allowing you to keep your account even if you change jobs. The HSA balance will remain in the account if you do not spend it all.
Managing Your HSA
As long as you have a high deductible health plan and are not currently enrolled in Medicare, you can participate. After you enroll in Medicare you are no longer eligible to make contributions to your HSA account, but you can take distributions. For any year you or your employer make a contribution to your HSA—or you take a distribution from your HSA—you must file Form 8889 with your income tax return to report these items. If your employer sponsors your HSA, understand the available investment options and create an investment strategy based upon your goals.
Making the Most of Your HSA
For 2023, the maximum yearly deductible contribution is $7,750 for families and $3,850 for individuals, plus $1,000 for each account holder age 55 or older.
When to Take Distributions from Your HSA
Assuming you are fully funding your 401(k) plan each year, we recommend that you pay for qualified medical expenses (QMEs) out of pocket rather than with a distribution from your HSA. This way, the funds in your HSA will continue to grow tax-free. Keep records of QMEs you have paid out-of-pocket before you turn 65, as they can be reimbursed with tax-free HSA distributions once you turn 65. (If, however, you are not fully funding your 401(k) or IRA, or you have outstanding high-interest debt, it is better to use your HSA to pay for QMEs so that you can fund a retirement account and avoid accumulating more debt.)
It’s important to understand how distributions are taxed.
- Prior to age 65: Distributions from your HSA for QMEs are tax-free, but distributions for any other expenses are subject to income tax, plus a 20% penalty.
- Age 65 or older, or disabled: If you meet either of these two conditions, you can take penalty-free distributions from the HSA for any reason. Income taxes will be assessed on non-qualified medical expenses. Distributions for QMEs will still be tax-free.
Allowing money to accumulate in your HSA will provide you with an alternative retirement fund, similar to a 401(k), with the added bonus of tax-free distributions for qualified medical expenses.
Estate Planning Concerns
Upon your death, the status of your HSA depends on who you have designated as your beneficiary. If the beneficiary is your spouse, your HSA will be treated as your spouse’s HSA upon your death, in a nontaxable transfer. If the designated beneficiary is someone other than your spouse, the account loses its HSA status, and its fair market value becomes taxable to the beneficiary in the year of your death. If your estate is the beneficiary, the value of the HSA is included on your final income tax return.
Conclusion
A health savings account can be a useful tax-free savings vehicle. You’ll get the biggest benefit if you can avoid taking distributions while you are working and instead use the accumulated balance for medical or other expenses in retirement. HSAs provide tax-free growth while also allowing tax-free distributions for qualified medical expenses; distributions for non-QMEs are subject to a 20% penalty unless you are age 65 or disabled, at which point distributions for non-QMEs are subject only to income tax.
As long as you are able to fund your HSA with a provider that offers a variety of investment options and you can afford to let the money accumulate until at least the year you turn 65, your HSA may help you increase your wealth and standard of living in retirement.
