The Health Savings Account (HSA) is the third account in the Phippen Tax Accounts You Need Now series because it can provide a safety net for your health, pay qualified medical expenses with tax-free money, and even help you save for retirement. To refresh your memory about this account, here is why you need one:
In the short term, you need it to protect yourself from any health emergencies. If you are lucky enough not to experience any, you can use an HSA to invest for retirement, or expected health expenses of old age, with a pre-tax investment.
Why an HSA?
An HSA provides a tax-free avenue to pay for qualified medical expenses. Why does that matter? Usually, every dollar you earn is taxed at a rate of at least 10% according to the 2022 tax rates. When you earn $1.00, you receive $0.90 after taxes. However, if that dollar is used towards a qualified medical expense via an HSA, you get the entire $1.00.
The IRS list of what meets the threshold of a qualified medical expense includes the typical co-payments for doctor’s visits, but it also includes ambulance expenses, feminine hygiene products, infertility treatments, physical therapy, stop-smoking programs, and more. Additionally, certain childcare and eldercare expenses also qualify, potentially saving your family from paying taxes on a pricey recurring expense.
TRIPLE Tax Savings
HSAs are the only triple tax-advantaged account. An individual can contribute pre-tax dollars to an HSA, invest those contributions to realize tax-free growth, and use the money tax-free on qualified medical expenses. The three times where you realize tax savings with an HSA are:
Contributions are pre-tax, meaning you do not pay any taxes on the part of your salary committed towards your HSA. (This applies even to Social Security and Medicare taxes, not just income taxes as with a traditional 401(k) or IRA.)
Growth is not taxed. Funds in an HSA can be invested like a brokerage account. Unlike a brokerage account, the gains received as the money grows are not subject to taxation.
Use the money to pay qualified medical expenses. No taxes apply on the money removed from the account.
A word of caution: Unless you are at least age 65 (see below), do not use the funds in your HSA for any purpose other than to pay qualified medical expenses. If you use HSA money to pay for a vacation, you will pay income tax plus a 20% penalty on the amount withdrawn.
Logistics: Who Should Contribute and Maximum Contributions
The main downside to the HSA is only certain individuals are eligible to contribute to one. A person can only contribute to an HSA if they have a High-Deductible Health Plan (HDHP).
Of course, HDHPs are not right for everyone. If you or someone in your family have or anticipate having expensive or unique medical needs, you may need a plan with more extensive coverage. In general, the younger and healthier you and your family are, and the fewer preexisting conditions you must address, the more likely the HSA is a good choice for you. An HDHP still offers competitive health care options, allows you to seek preventative medicine to maintain your good health, and prevents you from experiencing the financial detriment of an unpredictable catastrophic event.
If an HDHP is right for you and your employer offers an HSA, you can enroll in the HDHP and elect to contribute to an HSA. Once you sign up for an HDHP and elect to contribute to an HSA, your employer will provide you with information about how to set up your HSA account. You can also maintain an HSA not through an employer – for example, if you are self-employed – as long as you have an HDHP. Going through an employer, however, is the simplest route and the only way to save on Social Security and Medicare taxes. Once set up, you can actually invest the funds in your HSA as you would a retirement account, like a 401(k)!
Since HSAs are a tax-advantaged account, there is a limit for annual contributions. In 2023, this limit is $3,850 for individuals and $7,750 for families. This means, if you are unmarried and have no dependents, you can contribute $3,850. If you have a spouse or just one dependent on your HDHP, you are eligible to contribute $7,750. If you are age 55 or older, you can make additional “catch-up” contributions of up to $1,000 as well. You can also contribute less than the maximum amount if that is what your current financial situation allows.
If you are interested in more information about how to maximize your tax-advantaged contributions in 2023, make sure to check out our article Maximize 2023: New Contribution Limits.
Bonus Quality: The Best Retirement Account
If you missed it above, HSAs are not just an account where your money sits, unchanged, awaiting your qualified medical expenses. You can invest the funds in your HSAs and realize growth like you would any other retirement account, and HSAs actually have more benefits than other retirement accounts. This is what makes them magical!
If you contribute to a traditional 401(k)* or traditional IRA, you contribute money tax-free. Unlike other retirement accounts, HSAs are not subject to Social Security and Medicare taxes on those contributions. In both the retirement accounts and the HSA, that money grows tax-free. However, when you pull that money out of the 401(k) or IRA account to use it, you are taxed. When you follow the same process with your HSA, you can still remove the money from the account tax-free even though it grew, assuming it is used for a qualified medical expense.
The HSA is also more magical than a Roth 401(k) or Roth IRA since the HSA is funded with pre-tax dollars. The Roth accounts grow tax-free and can be removed tax-free, but you must contribute post-tax dollars to fund them.
Another Triple Threat: Choices for Using the HSA
There are three different opportunities to reap the advantages of this magical account. They vary in complexity, but all three provide huge benefits:
1. Use tax-free dollars to pay for any qualified medical expenses you encounter. This is the simplest way to use an HSA since you contribute the money, use it when you need to, and potentially invest some to grow in case you have larger expenses in the future.
2. Let the HSA grow, tax-free, while paying for your qualifying medical expenses out-of-pocket. This is our favorite one. If you have enough money elsewhere to pay for your qualified expenses now, you can invest the funds and let the HSA grow. You can then save the receipts from any qualified medical expenses and pay yourself back for them at any point in the future. This means, you could buy Claritin in 2023, save the receipt, your HSA could quadruple in size by 2037, and then you could withdraw that money tax-free to pay yourself back for that Claritin 14 years later!
3. Use your HSA as another retirement account. The HSA can also be used like a bonus traditional IRA. You can remove the money from the account without penalty for any reason after age 65. If you use the money for expenses other than qualified medical expenses at this point, you do have to pay income tax on the money, but no other fees are required.
All three methods are terrific and improve your finances. You also may pick a path in the middle where you pay for some expenses now but invest some of your HSA for retirement. Do what works best for your situation, and adjust as your life changes. These magical health-or-retirement accounts provide a lot of flexibility and opportunity to save for health or wealth!
*For the purposes of this article, when we say “401(k),” the same is true for a 403(b), 457, or TSP.
About the Financial Accounts Series: The Financial Accounts Series is a four-part series discussing financial accounts that can improve the health of your finances. The Phippen Tax & Financial Services team will provide a deep dive on each of the accounts listed in Part 1, Accounts You Need Now, before releasing Part 2, Accounts You Need Next. If you would like to seek additional guidance about your personal finances or the specific organization and composition of your financial accounts, please contact Patrick Phippen or complete a new client form if you have not worked with Patrick in the past.
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