A Health Savings Account (HSA) is the most efficient tax-advantaged investment account because it offers a triple tax advantage:
- Contributions are tax-deductible
- Earnings grow tax-free
- Withdrawals are tax-free if used for medical expenses
HSA Rules
- You need a high deductible health plan (HDHP). You cannot contribute to an HSA without one. According to the IRS, a “high deductible health plan” is defined under § 223(c)(2)(A) as a health plan with an annual deductible that is more than $1,600 for self-only coverage or $3,200 for family coverage, and for which the annual out-of-pocket expenses (deductibles, co-payments, and other amounts, but not premiums) do not exceed $8,050 for self-only coverage or $16,100 for family coverage.
Importantly, you need to determine whether a high deductible health plan is right for you. You will generally receive the biggest benefit from an HDHP if you are in good health. I will also provide an example of how to run the numbers in the later section.
- You aren’t enrolled in Medicare
- You can’t be claimed as a dependent
Contribution limits
The 2024 contribution limit is $4,150 for an individual plan and $8,300 for a family plan, with an additional $1,000 catch-up contribution if you are 55 or older.
The contribution limit includes both your contributions and your employer’s contributions.
Quick example
Here is a quick example: suppose you have an HDHP and an individual plan for the same cost (generally HDHP will be actually cheaper). With an HDHP, you can contribute a maximum of $4,150. If you are in a 30% tax bracket (federal + state), these contributions will generate $1,245 in tax savings. In addition, that amount will grow tax-free. If you have no medical expenses, you save $1,245 compared to the conventional plan.
Now, if you have $3,000 in medical expenses under the HDHP and pay them from your HSA, while the conventional plan requires you to pay $750 for the same expenses, the conventional plan is a better deal ($3,000 – $1,245 (tax savings)< $750).
Sometimes your employer may provide subsidies toward your HSA, so that’s also something to consider. It’s difficult to predict your medical expenses over the years, but you know yourself better than anyone else.
How does it work?
The account typically works like a bank account, where you make deposits and can withdraw money with online transfers/checks. The bank also allows you to link the account to a brokerage account.
Withdrawals
Withdrawals for medical expenses are tax-free. IRS Publication 502 has information about which expenses qualify as medical expenses.
In addition, as long as you keep proper records, you can reimburse yourself in a later year.
For example, say you contribute $1,000 to an HSA. You paid for all expenses out of pocket without touching the HSA account. In 30 years, that $1,000 grows to $10,000. You can then reimburse yourself for all the expenses you incurred over these 30 years. Why would you do that? Because you allow that $1,000 to grow tax-free, benefiting from compound interest. Just make sure you save all the receipts!
Once you turn 65, you can withdraw money from your HSA for any reason without penalty. However, you will owe income taxes on any non-medical-related withdrawals, effectively making this similar to a Traditional 401(k) or IRA.
Investing
If you are paying medical expenses out of pocket (not with HSA funds) you should treat the HSA just like an investment account, thus you should invest as if it were part of your IRA or 401k.
If you are paying medical expenses with the HSA, you should have at least a portion of the funds in a Treasury Fund/Money Market Fund for stability. Generally this fund should be equal to at least one year of deductible cost.
Inheriting an HSA
Per Publication 969, if your spouse is the designated beneficiary of your HSA, it will be treated as your spouse’s HSA after your death.
If your spouse isn’t the designated beneficiary (i.e. your child is the beneficiary), the account stops being an HSA and the fair market value of the HSA becomes taxable to the beneficiary in the year in which you pass away.
This is why tax-free HSA dollars should ideally be spent before passing down an inheritance due to tax inefficiency. On the other hand, naming a beneficiary in a low-income tax bracket to receive the deceased person’s HSA is also beneficial for tax purposes.
How to create one?
If you are looking for an HSA provider, Fidelity offers a no annual account fee and no minimum to invest with a wide range of investment options. They are rated the #1 HSA by Morningstar.
I hope you learned something new today!
See you next Saturday.
MC