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Health-savings accounts (HSAs) have been around for a while, but they still remain a mystery to many Americans. While not everyone has the option to participate in an HSA and take advantage of the hidden benefits, even those who do often don't use them to their full potential. A recent report revealed that approximately 73% of employees with an HSA contributed to their account in 2021, leaving many eligible workers who haven't opened an account or haven't contributed or invested the money for growth. This is a missed opportunity, as HSAs offer triple tax benefits: deposits are tax-deductible, growth is tax-free, and withdrawals are tax-free if used for qualified medical expenses.
With the open-enrollment season for healthcare insurance in full swing and 2024 contribution limits for HSAs increasing, it's a good time to consider the benefits of opening or optimizing an HSA. Here is what you need to know.
What is an HSA, and am I Eligible?
An HSA is a type of savings account. It allows you to set aside money on a pre-tax basis to pay for qualified medical expenses. It can also earn interest, which is not taxable. Many people confuse health-savings accounts with flexible-spending accounts (FSAs), thinking that the money in an HSA must be used within a given year. It does not! The money in an FSA, however, does need to be spent by the end of the year in which it is contributed. In reality, HSAs allow you to contribute and invest money for the long term. If you start an HSA early, fund it consistently, and invest wisely, it can help cover medical bills in retirement. It will also produce tax-free income through reimbursements for past medical expenses.
“Put the money inside the HSA and let it actually grow,” says Brian Copeland, director of financial planning with Hightower Wealth Advisors in St. Louis. “Don’t just think of it like a flexible-spending account. It is way better.”
An HSA works in tandem with an HSA-eligible health plan. To contribute to an HSA and unlock the hidden benefits, your employer must offer a high-deductible health plan. Many do, as over 50% of private-sector workers in the US were enrolled in these plans in 2021. High-deductible plans typically have lower premiums but higher out-of-pocket costs. It's essential to assess your health, family needs, and how often you need medical treatment before choosing a high-deductible plan.
What are the Benefits of an HSA?
Assuming a high-deductible plan suits your needs, contributing to an HSA offers several advantages, including the potential for long-term growth and tax-free withdrawals. You can save receipts for qualified medical expenses and withdraw tax-free reimbursements from your HSA in retirement. Using an HSA instead of a 401(k) for medical expenses in retirement can save you money. To reiterate: it is important to remember to save receipts! If the IRS comes asking, you need to have a record of activity in and out of that account over time.
HSA funds can also be used for various medical expenses, including deductibles, copayments, coinsurance, and, in some cases, long-term care insurance premiums. These hidden benefits can be tremendously useful down the road. The average couple will face over $315,000 in out-of-pocket medical expenses in retirement, according to data from NFP. Having a fund that is not taxed upon withdrawals, such as an HSA, greatly reduces the gross distribution of money needed to cover these expenses.
Why Should I Invest the Money?
While many people contribute to HSAs, not all take full advantage of the hidden financial-planning benefits. Some leave their funds in cash or don't invest them. You can invest your HSA money for potential growth in things like mutual funds, stocks, and bonds. Even if you opt for a high-deductible plan to save on premiums, consider investing the money you save in your HSA for future medical expenses.
Similar to 401(k)s, HSAs should be reassessed at least once a year to align with your overall financial goals, target allocations, and risk tolerance. Rules regarding HSA contributions may change if you enroll in Medicare, so consult a tax professional in such cases. Avoid double-dipping by not using HSA funds for expenses you've taken a tax deduction for.
If your employer doesn't allow you to invest your HSA funds, consider third-party HSA providers that offer investment options. These options allow you to reduce your taxable income by declaring contributions at tax time.
Should I Contribute to both a 401(k) and an HSA?
It's generally advisable to contribute at least the minimum amount to your 401(k) to get the full employer match before turning to HSA contributions. That is free money from your work, and should be prioritized. Beyond that, however, many people often continue to fund their 401(k) above the employer match. You may be better off putting that excess money in an HSA instead. That money will likely be needed for future medical expenses in retirement. After maxing out your HSA, you can continue funding your 401(k) up to applicable limits.
Using HSA funds for non-qualified expenses before age 65 can result in a 20% withdrawal penalty from the IRS, plus taxable income. After 65, this penalty does not apply. Additionally, the IRS considers HSA funds spent on non-qualified expenses as taxable income. The HSA is designed as a healthcare-related savings tool. Therefore, it's best to use your HSA primarily for healthcare-related savings until you've exhausted other retirement savings options.
HSAs offer a host of tax benefits and can be a valuable addition to your financial planning toolkit. Understanding their potential and how to make the most of them is crucial for securing your financial future. So, during this open-enrollment season, consider how an HSA can benefit you and your long-term financial health!
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