The Ultimate Retirement Account – Health Savings Accounts (HSA)
I’m sure most people who have made it to our website have a general understanding of the differences between a Traditional IRA and Roth IRA. With a Traditional IRA, you get a tax deduction in the year you make the contribution, then pay taxes when you withdraw the money. In a Roth IRA, you do not get a deduction now, but instead take qualified withdrawals tax-free. Both types of accounts allow for tax-deferred growth.
However, there is a lesser-known savings vehicle that allows for tax-deductible contributions, tax-deferred growth, and tax-free withdrawals – The Health Savings Account (HSA).
The Health Savings Account, in its current form, came to be in 2003 under the Bush Administration’s Medicare Prescription Drug, Improvement, and Modernization Act. This was an evolution of the less-efficient Medical Savings Account (MSA) and Health Reimbursement Arrangements (HRA). The idea was to incentivize consumers with healthcare plans carrying high-deductibles to save for potentially large healthcare expenses.
Can I Contribute to an HSA?
First and foremost, you must have what the government deems a “High-Deductible Health Plan” (HDHP) in order to be eligible to contribute to an HSA. The guidelines for this are pretty straightforward:
Source: US Centers for Medicare & Medicaid Services
As long as you have a “High-Deductible Health Plan”, you should be able to contribute to an HSA. Many employers that offer HDHP options for health insurance, also may also have an arrangement to allow you to open an HSA as well. You should be able to talk to HR to determine your options.
If your employer doesn’t offer direct enrollment to an HSA, you can simply open your own. Most banks offer some form of HSA. For the purposes of our “Ultimate Retirement Account”, you’re going to want to open an account that will allow you to invest the balance of the account.
As I mentioned before, an HSA can allow you to contribute pre-tax and make withdrawals tax free. However, in order for everything to work just right, the withdrawals need to be qualified medical expenses. When you take money out of your HSA, it’s going to be one of three ways:
|Type of Distribution||Tax Consequences|
|Qualified Medical Expense (Any Age)||Tax-free|
|Non-Medical Expense (Age 65 and older)||Income tax on full amount of distribution|
|Non-Medical Expense (Age 64 and younger)||Income tax on full amount of distribution, plus 20% penalty|
However, for the purpose of optimizing our Ultimate Retirement Account, the only distributions we will ever take will be Qualified Medical Withdrawals. Now, what I’m going to suggest next may sound strange. I’m going to tell you to not take qualified distributions when you incur medical expenses during your working years. Instead, these medical expenses should be paid out-of-pocket (assuming you have ample savings to support the expenses).
You may notice that if you take a non-medical withdrawal after age 65, it is no different than a Traditional IRA. So, if you don’t end up incurring medical expenses, you can still access the money as if you had simply been contributing to an IRA.
The real key to utilizing an HSA is that there is no rule or law stating that you need to pay for expenses directly with your HSA or within a certain amount of time after incurring the expense. What this allows us to do is reimburse ourselves whenever we’d like extra, tax-free income.
For example, if a 38-year old were to have $1,000 of medical expenses in a year she could pay for this out of a savings account and save a receipt/invoice of this expense. Twenty years later, she could take a $1,000 distribution from her HSA, reimbursing herself for the expense she incurred back in 2016, and use it for groceries, a vacation, or anything she’d like. During those twenty years, that $1,000 has been able to grow tax-free inside of the HSA and is likely worth several times that original amount.
The secret to employing an HSA effectively is allowing the money to grow as much as possible under its excellent tax-advantages.
I’m going to be very upfront and say that, in general, this is a strategy for an overall young, healthy person. Most notably, utilizing an HSA requires you have a high-deductible health plan. These health plans typically have very low premiums, but require large out-of-pocket expenses from the insured before the insurance beings to pay benefits. If you have chronic conditions or find yourself using medical services frequently, it’s unlikely that you will be able to benefit from taking out an HDHP.
It is also important to be aware that the penalty is much more severe for early, non-qualified withdrawals in comparison to an IRA (20% vs. 10%). These types of distributions should be taken as an absolute last resort.
Used properly, an HSA is an extremely valuable tool for maximizing tax benefits and asset growth, over the long-term.