A Health Savings Account (HSA) is becoming a popular but frequently misunderstood employee benefit. An HSA provides huge tax advantages so let’s dig in.
What it’s Not
I’m sure I’m breaking every literary rule by starting off with what an HSA is not, but for those of us who began our employment with Flexible Spending Accounts (FSA), this is important. FSA was also known as the use-it-or-lose-it account. An FSA was a way for you to have money taken out of your paycheck every pay period, pre-tax, and deposit it in an account. This account could be used for medical or childcare expenses depending on the type of FSA. You would then use that money over the course of the year to pay your expenses. If at the end of the year, you had money remaining, you would lose it. Where I worked, everyone got new glasses in December as they were scrambling to spend unused FSA money.
HSA Money Belongs to You
So for all of us who lived through FSA times, the HSA is very different. Money that you put into an HSA goes in pre-tax, but it is yours. There is no expiration.
What is an HSA?
An HSA is an incentive that insurance companies provide to entice you to sign up for a high deductible health plan. Anyone who’s been following along with any media outlet for the past 20 or 30 years has heard stories about skyrocketing medical costs and insurance premiums. I can feel your eyelids drooping, so we’ll end this discussion here. Costs are going up.
The High Deductible Health plan coupled with an HSA is an intriguing piece of insurance innovation. And yes, I giggled when I wrote that sentence. It is however, a pretty cool idea. The premise is that the insured (you) agrees to pay a greater portion of your medical costs in exchange for a reduction in your premium AND a tax-advantaged way to put those savings in an account to help pay the higher costs.
An HDHP with an HSA Means
- Your insurance premiums will be lower
- You will pay more for doctor visits, prescriptions, and other medical costs
- You can put money (premium savings or other money) into a health savings account
- Like a 401k, there are annual limits to the amount you can contribute
- There are tax advantages which we’ll talk about in a sec
Triple Tax Advantage
Show of hands, who likes to pay taxes? Just kidding. However, this is the greatest tax saving opportunity that exists today. Let me explain why.
No Tax Going In
The money that you add to an HSA is pre-tax. Typically this will be done through your paycheck. I am retired and I have an HDHP with an HSA. Since I’m not getting a paycheck, I put money into my HSA directly and then record this on my tax forms at the end of the year.
No Tax on Growth
Here is another big difference with an HSA (v. the FSA). The HSA is a brokerage account that you own and control. You can log in to your brokerage site and see it, see the balance. And you can invest the money that is in your HSA. We’ll talk a lot more about investing your HSA money because this is almost as exciting as the triple tax advantage. For now, it’s important to know that any growth on your investment is tax-free.
No Tax When Used for Qualified Medical Expenses
In general, you can use HSA money for any medical expenses – some insurance premiums, prescription drugs, co-pays…check with your HDHP plan administrator for details, but there is a lengthy list. This isn’t a trick. It’s your money and the government provides the tax break to help you pay your medical expenses.
How Does it Work?
Setting up an HSA
As we talked about above, you first need to enroll in a high deductible health plan (HDHP) that is eligible for an HSA. This is usually specified in the plan title. My Plan is the HMO HSA 3400 Flex. But check with your employer, health insurer or health plan documents to be sure. My employer set up the HSA account for me and it magically appeared in my list of accounts on the website. Check with your employer.
You’ll need to set an HSA up yourself if you are not employed or are self-employed. It’s a pretty simple process but will differ depending on the brokerage firm you use.
Funding Your HSA
This is easy if you’re employed. As part of your annual enrollment when you choose your plan, you’ll determine the amount to be withdrawn from your paycheck (not to exceed the annual limits).
If you’re not employed or self-employed, you will deposit money into the HSA you established. When you submit your taxes, you will get a credit for the amount you’ve contributed. IRS limits apply whether you are employed or not.
Investing in Your HSA
Now the fun part.
Years ago when I first enrolled in a HDHP and set up my HSA, I got an HSA debit card in the mail and started right away using the money I deferred into this account to pay medical expenses using the convenient debit card. I was so proud.
A year or so later, I had an epiphany. This money doesn’t go away like an FSA, it is in a brokerage account, it has the triple tax advantage we’re so excited about, why don’t I invest instead of spending. Triple Tax point #2. No Tax on Growth. This is like a super-charged IRA or 401k because there were no taxes going in, no taxes on growth, and no taxes going out either as long as I use it on medical expenses. Why not try and maximize growth?
I expect that my medical expenses will go up as I age, so I am not worried that I will run out of expenses to spend it on. And after 65, I can withdraw from my HSA for non-medical expenses, I just need to pay tax on the distribution. I still get the tax benefit on the pre-tax contribution and the earnings growth.
So I put it in a low cost S&P 500 fund and let it grow. I’ve got years before I’ll take it out so I’m not concerned about market volatility in the short term. As I get closer to needing the money for medical payments, I will start to migrate towards fixed income and cash. See my post on asset allocation here.
Is an HSA Right for Me?
There is no easy answer. I was lucky. I started a High Deductible Health Plan and Health Savings Account somewhere around 2008. My wife and I had a couple of good health years – Regular check-ups, but no other doctor visits. Then came the year of the million dollar toe.
I hurt my toe on a golf trip where there may or may not have been drinking going on. Anyway, I get home and went to the doctor. Without really thinking about health coverage, I went for an x-ray, had a follow-up visit, and a couple treatments and the bills started coming. My wife and I were stunned. But that’s what a high deductible plan is all about – shifting the cost burden to the insured (me) in exchange for lower premiums and the tax advantages of an HSA.
I continue to choose an HSA because our health has been good and because I like paying as little as I can for insurance premiums, even if the risk of high out of pocket costs are there. My HSA has grown steadily. I took it on the chin in 2008, but being invested in an S&P 500 fund in 2009 – 2019 was a delight. A couple rocky periods since, but I’ll wind up ahead.
Look back at the compounding post for how the magic of compounding can grow your wealth. Time was on my side for the HSA so it was the right decision for me. If you’re in a situation where a series of large medical payments – like the million dollar toe – could upend your budget, it may not be right for you.
In Summary
A lot to consider, but with the facts in hand, you’ll be better prepared when annual enrollment rolls around. Please share your thoughts and questions.