The Ultimate Guide to Health Savings Accounts

Health Savings Accounts (HSAs) were created in 2003 so that individuals covered by high-deductible health plans could receive tax-preferred treatment of money saved for medical expenses.

Ok, that sounds great but what does that really mean? And why are they so popular in financial planning? Here is my guide through everything you need to know, including some planning strategies and lesser-known tax rules that can allow you to optimize your savings.

Part 1: The Basics + Taxes

First, let’s cover what we’re even talking about and how you can qualify for opening a Health Savings Account (HSA).

At its highest level, the HSA is a savings account that is specifically created to pay for medical expenses.

In order to be able to open a Health Savings Account, you must be enrolled in a High Deductible Health Plan (HDHP). Most employers will offer an HSA-eligible HDHP to their employees. If you are self-employed or are not offered health insurance through your employer, they are also available in the open market (e.g. through healthcare.gov).

Let’s talk briefly about how a HDHP differs from the other main categories of health insurance.

• Preferred Provider Organization (PPO) - PPO plans provide more flexibility when picking a doctor or hospital. They also feature a network of providers, but there are fewer restrictions on seeing non-network providers. In addition, your PPO insurance will pay if you see a non-network provider, although it may be at a lower rate.

• Health Maintenance Organization (HMO) - An HMO gives you access to certain doctors and hospitals within its network. A network is made up of providers that have agreed to lower their rates for plan members and also meet quality standards. But unlike PPO plans, care under an HMO plan is covered only if you see a provider within that HMO’s network. There are few opportunities to see a non-network provider. There are also typically more restrictions for coverage than other plans, such as allowing only a certain number of visits, tests or treatments.

PPO plans generally come with the highest monthly premium, followed by HMO plans. When families who are covered by PPO and HMO plans seek medical attention, it will generally be paid via relatively low co-pays.

On the other hand, High Deductible Health Plans will usually have a lower premium. Some companies will actually cover 100% of the premium for single employees. Most HDHPs will also cover a level of preventative medical visits, such as an annual physical.

The trade off of the HDHP comes when it relates to other visits and procedures in that the insurance company doesn’t start picking up the bill until after the deductible is met. So instead of a nice $20 copay, you pay close to the full amount of the medical procedure / visit.

Well that sounds kinda lame, right?

Uncle Sam thought so, too. In order for the HDHP to make sense for people, the government also established the Health Savings Account.

How Does the HSA Work?

First, let’s make the distinction that an HSA is different from a Flexible Spending Arrangement (FSA). The FSA is the one where you put money into it each year but it has the “use it or lose it” rule, meaning you’re unable to carry over a balance from one year to another (it’s actually a little more nuanced b/c technically there is an option where you carry over $500, but I digress). Also, the FSA is linked to your job.

The HSA is an account that YOU own. If you leave your current job, your HSA sticks with you. It’s a good friend like that.

There is no rule saying you have to spend down your HSA, meaning you can keep accumulating savings inside of the account indefinitely.

How do you get money into the HSA?

There are two primary ways of funding your HSA:

1. Directly deposit money into it.

2. Tell your employer to put a set amount per paycheck. This one is preferable because when your employer does this, then you don’t have to pay Social Security or Medicare tax on the money that goes into the HSA

Additionally, some employers provide an extra benefit of funding a portion of your HSA (which is a great perk).

How Much Can I Save In An HSA?

Like all tax-advantaged accounts, there is a limit to how much you can contribute into an HSA. The recently released 2021 numbers are:

• Single: $3,600

• Family: $7,200

• Additional catch-up contribution for those 55 and older: $1,000

An important note is that any employer contributions also counts towards this limit, so plan accordingly!

How Is It Taxed?

This is where the HSA really can shine.

1. It is not taxed on the way in, meaning it is deducted from this year’s earned income

2. It is able to grow tax-deferred while inside of the account (more on this in Part 2)

3. If used to pay for qualified medical expenses, it can be withdrawn tax-free!

Sometimes you’ll hear people say that it has a “triple tax advantage”, and this is what they’re talking about.

If you also count being able to avoid paying SS/Medicare when your employer is the one putting aside part of your paycheck, then you could say it has a “quadruple tax advantage”. But that just doesn’t have the same ring to it, I guess.

Part 2: The Secret Retirement Account

When thinking about where to save for retirement, most people think about your 401(k) and your IRAs. But let’s talk about why the HSA might be the first place that you want to look.

One of the first things to establish is that, with an HSA, you can think of it as being two types of accounts bundled into one:

1. Cash / checking account

2. Investment account

When you first deposit money into your HSA, it’ll go into the cash account. This account is also what you’ll use to pay for medical expenses (you’ll have a debit card linked to this account)

But you can also elect to move some of the money from the cash side into the investment side. Once in the investment account, you will be able to choose to invest in different mutual funds, similar to what you’d find in a 401(k) plan.

Knowing that and having money in these investments, you can start to see why the HSA can be used as another retirement investment account!

We just talked about how it’s not taxed on the way in. Secondly, it’s able to grow tax-deferred (now that we know we can truly invest in here).

But what if it you decide to use HSA money for non-qualified expenses? The way its treated is that it’s going to be taxed AND you’ll also get a 20% penalty.

Ouch.

Now The Secret Part

There is a rule that as soon as you turn 65 years old, then the 20% penalty goes away.

What you have at this point is an account where money is: 1.) not taxed on the way in; 2.) grows tax-deferred; 3.) taxed as ordinary income at withdrawal.

That sounds an awful lot like a traditional IRA or 401(k)!

So if you’ve accumulated a lot of money into your HSA by 65 and you want to take money out to go on a trip or buy a boat, then it’ll get treated the exact same way as if you withdrew from your IRA.

Keep in mind you can still be using it for medical expenses (and I’m willing to bet you’ll have medical expenses in retirement as well) and then you’re able to get the full “triple tax advantage”!

Part 3: The Power of Delayed Reimbursement

So now you’ve decided to call your HSA another retirement account. But what is one of the cardinal rules to follow whenever you’re saving for retirement?

You don’t want to take money out before you need it in retirement!

When you “unplug” your investments, then it undermines the power of compound interest. So to take full advantage of tax-deferred growth you want your money to stay invested and in this account as long as possible and have as much money as you can left in the account.

Here is the tax rule that can allow you to keep the money in your HSA, let it grow, and still withdraw it tax-free! (Bold letters added for emphasis)

Q-39. When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?

A-39. An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year.

An Example

Let’s say that you do get a medical expense. You go to the hospital and you have a $2,000 medical bill. You now have two options:

1. Take money out of the HSA & pay the medical bill - It’s a qualified medical expense, no taxes due on the $2,000. Done.

2. Leave HSA alone and pay the medical bill out of pocket - If you have the means to do this, you don’t have to touch your HSA and can allow it to stay invested and keep growing.

If you choose #2, here’s the really important piece. You will need to keep detailed records & receipts that show that:

• Your medical expenses weren't paid for or reimbursed from another source.

• You didn't take an itemized deduction for these medical expenses in any year. (Double-dip)

In the future, whether it’s one year down the line or 30 years later, you can use these records to take $2,000 out of the HSA. Since you have proof of this qualified medical expense (from a prior year), it can be withdrawn tax-free!

That’s the strategy. I’ll leave it up to you as far as whether you think it is worth the headache of keeping these records or if you just want to pay the medical bill straight from the HSA and not have to worry about it.

Part 4: The Most Important Thing

We’ve talked about all of these great benefits of a Health Savings Account: The tax advantages; being able to invest it; a tax loophole that allows you to keep it invested for a longer period.

Let’s take a step back and talk about the most important thing, and it has nothing to do with money.

Something that I think is an unintended consequence of the High Deductible Health Plan is that, since it’s not just the $20 copay and you’re actually paying either out of pocket or out of your HSA for any sort of medical attention or going to the hospital, then there’s a tendency to second-guess whether you should actually go.

You want to stay invested, right?! You don’t want to undermine what you’ve saved, do you?! Think of the financial ramifications!

While there is a healthy level of thinking through these decisions, still the most important thing is that you and your family are staying healthy and getting the medical attention that you need.

While I know it’s difficult to sometimes let go of that, it’s really important to understand and keep in mind when deciding whether you go seek medical attention or not.

Like I always say, all of this financial planning stuff… it’s not really about money.

It’s about living a life that is healthy, keeping your family healthy, and being able to do the things that you want to and live a life truly aligns with your core values!