HSA: The Best Retirement Account You’re Not Using

And How to Open One Today

Don’t be fooled by the name Health Savings Account (HSA)…

HSAs are really retirement accounts in disguise. And if you’re eligible for an HSA, you definitely want one, because they combine all the best features of other retirement plans… and then go another step further.

If you use your HSA the right way, you have 100% tax-free money.

  • Current year tax deduction
  • Tax-free growth
  • Tax-free withdrawals

These accounts have built-in tax advantages like retirement accounts… but without all the restrictions on using them. So if you do need to access the money for medical expenses before you retire, you won’t face any tax consequences at all.

In fact, as long as you use the funds in your HSA to cover medical expenses, you’ll never pay even one-cent of tax on it at all – and that includes all the growth that accumulates over time.

Why You Need an HSA

At some point, you will need to pay for medical care – everyone does. And because HSAs work together with high-deductible health plans (HDHPs), you can use them to cover your deductible and all of your co-pays with untaxed money.

Right now, if you have an extreme amount of medical costs, you might get a tax break. There are tax deductions for medical expenses, but only if they reach more than 10% of your taxable income… and that first 10% is not tax-deductible.

HSAs do an end run around that, letting you deduct your contributions before you actually pay for health care costs. That’s a much better deal than paying for expenses with after-tax dollars and then trying to get some of that money back. Plus, health care costs can be outrageously high, and you may not find out just how high until after the fact. That’s especially true as you get older, because almost everyone uses more health care services later in life.

So by stashing cash in an HSA account now, when you’re not using a ton of health care services, you can build up a huge medical spending nest egg for whenever you do need it. That means you won’t have to pull money from your retirement savings to cover doctor bills after you stop working.

And if you never need it to pay for medical expenses, you can just use it like another regular retirement account.

Win-win.

HSAs Come with Triple Tax Advantages

If you’re looking for a way to save or invest money while avoiding present and future taxes, an HSA can make that all happen. HSAs come with a trio of tax-saving benefits that boost your finances now and later.

The three HSA tax hacks are:

  • Contributions lower your tax bill today
  • HSA earnings (like interest, dividends, and capital gains) grow tax-free
  • Pull out money (contributions and earnings) at any time with no tax hit…as long as you follow the rules

No other tax-advantaged account offers all three of these benefits in one – not even Roth IRAs.

Don’t Confuse HSAs with FSAs
There are huge differences between HSAs and FSAs (flexible spending accounts). The biggest are the use-it or lose-it rules. HSAs are permanent accounts that stay with you from day you open them. FSAs disappear at the end of the year, and any money left in them disappears, too. If you have money in an FSA, spend every penny.

How to Start an HSA

There are basically two ways to open and fund an HSA: through your employer or on your own.

If your employer offers an HSA plan, take advantage of it. When you make contributions this way, you’re funding the account with pre-tax dollars. That means your contribution comes out of your paycheck before you pay taxes on it. When you have lower taxable income, it also reduces your other withholding taxes resulting in more take-home pay for you. Plus, if your employer contributes toward your HSA, that’s more free money for you. You get the same tax benefit if you DIY your HSA by opening and funding an account on your own. Your contributions will be tax-deductible, reducing your current taxable income and your year-end tax bill. (More on this below.)

Once you have money in an HSA, you can start investing it. That means the money you have sitting in your HSA has the chance to grow. And because the money you earn inside your HSA is tax-exempt, meaning you don’t have to pay any income taxes on them every year like you would for regular accounts, your balance will grow even faster.

HSAs Come with Big Tax Advantages and Lots of Rules

As long as you use the money in your HSA to pay for qualified medical expenses (see the list below), your withdrawals will be 100% tax-free. No matter how much money you pull out, no matter when you take it, you won’t pay any taxes.

If you use the money for anything else, you could face tax penalties of up to 20% plus regular income taxes on the amount you withdrew. That is, until you turn 65.

Once you turn 65, you can use this money for anything, any time, without facing any tax penalties. You’ll just have to pay income taxes on the earnings portion of the money you took out. This feature makes HSA perfect extra retirement accounts, where you can stash more tax-free cash even after you’ve maxed out everything else. Now, like most tax-advantaged savings plans, HSAs come with a bunch of rules. If you don’t follow them to the letter, you could get hit with fines, penalties, and a bigger tax bill. For the latest rules (they change periodically), check in with the IRS website.

How to Open Your Own HSA

If you’re self-employed or your employer doesn't offer an HSA, it’s easy to set up one for yourself. There are several online HSA providers to choose from, including Lively and Fidelity. You can also go to the bank (or credit union or brokerage) and set up your HSA in person.

Whichever custodian you go with, make sure you fully understand all of the fees, balance requirements, investment options, and how you can pay (or be reimbursed) for medical expenses.

To open your account, you’ll need to have the following information handy:

  • Your Social Security number
  • Your HDHP (high-deductible health plan) provider
  • Bank routing and account numbers
  • Picture ID (you can usually just take a picture of your license and upload it)

Once your HSA account is open, you need to fund it. The easiest way is to set up automatic transfers to the account, making sure you don’t go over the annual contribution limit.

And after your HSA is funded, you can start investing. Most providers offer a menu of ETFs and mutual funds, similar to what an IRA provider would offer.

Make sure your investment choices here fit in with your overall investment plans and also mesh with your current medical spending situation. For example, if you spend a lot of health care dollars every year, you may not want to incur the fees involved with investing this money. But if you rarely spend money on health care costs, you can consider this a  long-term investing account, and let the funds build up to help fund your retirement. 

But before you do any of this, though, make sure that your health insurance is a qualifying HDHP, or you could end up in a nasty tax trap.

You MUST Have an HDHP

HSAs can only be used in connection with high-deductible health plans (HDHPs). The IRS has a special definition for what counts as an HDHP, so make sure your plan qualifies before you open an HSA.

The first test involves the deductible, which is the amount you have to pay in healthcare costs before your insurance starts picking up the tab. The minimum deductible for 2020 is $1,400 for single coverage or $2,800 for family coverage. You’re deductible can be bigger, but it can’t be smaller and still qualify as an HDHP.

Double Check Family Plans
Be aware that certain family plans look like they qualify, but don’t. These plans have separate deductibles for the whole family and for each family member, and when one family member hits their individual deductible it counts for the whole family. If that individual deductible is less than the full family coverage deductible, the plan doesn’t qualify – and you can’t fund an HSA.

The second test looks at the maximum annual deductible and other out-of-pocket expenses (often this includes only in-network providers). The 2020 maximums are $6,900 for single coverage and $13,800 for family coverage.

These dollar amounts change every year, so make sure you have the latest information when you’re funding your HSA. You can get more information in IRS Publication 969, available at www.irs.gov.

What Can You Spend HSA Money On?

When you use your HSA money only for eligible medical expenses, you won’t have to pay any taxes or penalties at all, ever. Using the money for anything else (before age 65) triggers a tax bill or a request for you to put the money back into your HSA.

Luckily, the list of eligible expenses includes most things you’d expect along with a few pleasant surprises. Here are just some of things you can use your HSA money for:

  • Prescription drugs
  • Premiums for long-term care insurance
  • Co-pays for doctor visits
  • Acupuncture
  • Chiropractor
  • Bandages
  • Eyeglasses and contact lenses (and saline solution)
  • Pregnancy tests
  • Breast pumps
  • Mental health services
  • Medical-related travel expenses (such as taking a Lyft to the dentist)

You can use HSA funds to cover healthcare expenses for yourself, your spouse, and your dependents.

Be aware that you can’t use this money to pay off old medical bills from before you opened the HSA.

Know the Limits… and Don’t Go Over

You can fund your HSA every year up to that year’s contribution limits.

For 2020, the limits are $3,550 for individuals and $7,100 for families. If you’re over 55 (and you’re not enrolled in Medicare), you can also make a “catch-up” contribution of $1,000.

If you’re lucky enough to have an employer who contributes to your HSA, deduct that contribution from your annual limit. For example, if your HSA contribution limit is $3,550 and your employer contributes $250, you can’t contribute more than $3,300.

If you put in more money than the IRS allows, you’ll have to pay regular income taxes on that excess contribution plus a penalty tax every year until you fix the problem.

If you notice the problem before that year’s tax-filing deadline, take out the extra money and any related earnings, and report those earnings as income on your tax return (like you would for a regular investment account. The fix is more complicated when the excess contribution was made in a prior tax year, so it’s best to consult a tax professional for help.

Ready to open your HSA but have some more questions? Feel free to contact me with those questions, or set up a free consultation to see whether an HSA fits in with your financial plans.

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