This is the third Sycomore Saturday in a series on why I love Health Savings Accounts or HSAs. Take a look at Part 1 and Part 2 if you missed them.
One of the most common pushbacks against investing HSAs for the future is “What if I don’t have enough medical expenses in the future?” Let me explain three characteristics of HSAs that will help answer that question.
Generally speaking, you can’t use HSAs to pay for insurance premiums, however, there are exceptions to this- namely Medicare premiums (not including medicare supplemental policies). When you consider how much someone could pay in Medicare premiums and out-of-pocket medical expenses in retirement, it is not unreasonable to assume they will spend several hundred thousand dollars - particularly if the inflation on medical expenses is high going forward.
You don’t have to take distributions from an HSA in the year you incur the medical expenses. “You can receive tax-free distributions from your HSA to pay or be reimbursed for qualified medical expenses you incur after you establish the HSA” (IRS Publication 969). In other words, while you are investing your HSA, you could be saving medical receipts to be reimbursed at some point in the future. If you do this for several decades, you would give your HSA the opportunity to grow tax-free before you then pull money out of the account to reimburse for prior expenses.
Generally, if you withdraw from an HSA before age 65 and don’t use it on qualified medical expenses, there is a 20% additional tax in addition to having to include the distribution in ordinary income. After age 65, this additional tax no longer applies. You can withdraw for any purpose. You would still have to include the distribution in ordinary income (so it will still typically be better to use it for qualified medical expenses) but there is no additional 20% tax. The implications of this are significant. Even if I knew that I would not be using the HSA for qualified medical expenses, it is likely I would still rather save into an HSA than save into a Traditional IRA or Pre-Tax 401k. Why? Because after 65, distributions from any of these accounts will be subject to ordinary income tax (with exceptions) but on the contribution (if done by payroll deduction) the HSA could save you from Social Security/Medicare tax in addition to ordinary income taxes. The Traditional IRA and Pre-Tax 401k only saved you from ordinary income tax.
From the three points above, you can see why the HSA should be a prominent component of your future savings. It should not be your only account type and for some individuals it won't make sense. You can learn more about my savings hierarchy here.
There are even more characteristics of HSAs that make them an interesting planning tool. You can learn more details about the account by looking at IRS Publication 969.
After learning more about HSAs, hopefully you can see why they would make a financial nerd "fall in love.” Most people use HSAs for their everyday medical expenses. For some this may make sense, but others could be leaving thousands of dollars to potentially even hundreds of thousands of dollars on the table by doing so.
Interesting Article(s) or Video(s)
IRA Help - The Ghost Rule
A good reminder to confirm beneficiaries are updated as desired.
Thank you for reading! What questions do you have about HSAs?