Inu says, “I’ve heard your recent podcast about using an HSA and still have a question. I invest most of my HSA money in mutual funds, so taking money out means it loses investment growth. I’m wondering if it’s better to spend my HSA funds, or to just pay my medical expenses out of pocket when I can afford them, to keep the account growing?”
Thanks for your great question, Inu! In this post, I’ll review the benefits you get from using a health savings account (HSA) and whether it’s better to spend your balance on medical costs or keep it invested for the long term.
Triple Tax Benefits of Using an HSA
An HSA is a special type of account that you can set up for the sole purpose of paying qualified medical expenses, such as deductibles and out-of-pocket costs, on a pretax basis now or at any time in the future. You can contribute to one only if you have an eligible high-deductible health plan through an employer or as an individual.
An HSA offers three money-saving tax benefits.
1. Your HSA contributions are never taxed.
An HSA is funded with pre-tax dollars, whether you make contributions or your employer does so on your behalf. If you fund the account on your own, you claim total annual contributions as a deduction on your taxes (even if you don’t itemize deductions). If an employer makes your contributions, they’re deducted from your paycheck before taxes are taken out.
You can make tax-deductible contributions to an HSA at any time during the year, even up to April 15 for the previous tax year.
You can make tax-deductible contributions to an HSA at any time during the year, even up to April 15 for the previous tax year. You can contribute even if you’re retired, unemployed, or have annual income less than your contributions. And you’re never required to make HSA contributions.
For 2018, you or your employer can contribute a total of up to $3,450 to an HSA if you have insurance just for yourself, or $6,900 if you have a family plan. (The family limit was recently increased $50 from $6,850 due to a correction in the inflation adjustment calculations for the year.)
If you’re age 55 or older you or your employer can contribute an additional $1,000 to an HSA when you have either an individual or a family health plan.
2. Your HSA earnings are never taxed.
Most HSAs pay interest on your balance, just like a bank savings account. Plus, you typically also have the option to transfer all or a portion of your HSA to investments, such as mutual funds, to grow your balance.
Unlike with a taxable bank or brokerage account, interest or investment growth in an HSA is completely tax free.
3. Your HSA withdrawals are never taxed.
When you take money out of an HSA, there are no taxes. This is true no matter if you withdraw original contributions, interest income, or investment earnings from the account to pay for qualified healthcare expenses.
This can be more beneficial than taking money out of a retirement account, such as a traditional IRA or 401k, which do require you to pay income tax on withdrawals. An HSA even has more advantages than a Roth retirement account, which also allows tax-free withdrawals—but requires tax on your contributions.
Just like with a retirement account, you should never put money in an HSA that you might need for everyday expenses. You can only use HSA funds to pay for current or future qualified, unreimbursed medical expenses. Otherwise withdrawals are subject to income tax plus a hefty 20% penalty.
You’re never required to take withdrawals from an HSA. Your balance can stay in the account indefinitely and even be passed to your heirs.
An HSA is portable, which means you can take it with you if you switch employers or retire. You can continue spending it, even if you no longer have a high-deductible health plan or you become unemployed.
See also: What's the Difference Between a Roth 401k and a Roth IRA?
More HSA Benefits to Know
In addition to its triple tax advantages, there are even more benefits you get from using an HSA. In general, you’re not allowed to use it for health insurance premiums. But there are exceptions, including using HSA funds to pay for:
- Long-term care insurance at any age
- COBRA health insurance continuation after you leave a job
- Health insurance while receiving unemployment compensation
After your 65th birthday, there are even more allowable ways to spend your HSA, including:
- Certain Medicare premiums
- Health insurance premiums when offered by an employer
- Non-medical expenses that are penalty-free, but still subject to income tax
In other words, an HSA morphs into something that looks like a traditional retirement account if you keep it long enough. That’s a great reason to max it out every year, even if you don’t expect many medical expenses.
If you qualify for an HSA, they're available at many banks, credit unions, brokerages, and specialty institutions. Shop around to find one that gives you diversified investment options, low fees, and a convenient online experience. A couple of great places to open your account are Lively and HSA Bank.
See also: 7 Micro Habits That Create Financial Success
3 Strategies for Using an HSA
"Shoebox" your HSA, which creates an IOU to yourself that you redeem any time you like.
Because an HSA offers so many tax benefits and extra flexibility in retirement, you may be like Inu, who’s wondering if it’s better to spend the funds or keep them invested and growing year after year.
When you boil it down there are three strategies for using an HSA.
1. Make tax-free withdrawals to pay current medical expenses.
You typically receive a debit card with your account to pay qualified medical costs in real time. This is the traditional and most popular way to use an HSA, especially if you don’t have other savings to pay a medical bill.
If you have a remaining balance, you can let it grow for future use, including in retirement.
2. Pay medical costs out-of-pocket and make withdrawals in the future to reimburse yourself.
HSA rules don’t require you to pay qualified expenses within a certain period. If you have the cash to pay them, you can reimburse yourself later from the account and let the full balance stay invested and grow in the meantime.
This is known as “shoeboxing” your HSA, which creates an IOU to yourself that you redeem any time you like. Just be sure to keep good records to verify expenses, how they were paid, and that you didn’t take them as an itemized medical deduction on your taxes.
Also note that you can’t use HSA funds to pay expenses that occurred before you opened the account.
3. Pay medical expenses out-of-pocket with no reimbursement.
HSA rules don’t require you to reimburse yourself for qualified medical expenses. You can opt not to make any account withdrawals.
You could choose to pay small healthcare expenses out of pocket, and reserve your HSA for large or unexpected qualified costs. The idea is that the more money you keep in the account, the more time it can grow tax free.
See also: 7 Simple Principles to Invest Wisely No Matter Your Age
Should You Spend or Invest Your HSA Funds?
Let’s get back to Inu’s question about whether it’s better to spend your HSA or just keep it invested. The answer is it depends.
First, if you’re not maxing out a retirement account, be sure to do that before contributing more than your anticipated medical expenses to an HSA. Using an IRA or a workplace retirement plan, such as a 401k or 403b, should be your top investing priority.
While HSAs are loaded with tax benefits, they offer less flexibility than a retirement plan. Also, they’re not known for offering best-in-class investments with low fees. They can also come with additional account and investing costs, which may erode their net investment returns.
Spending your HSA gives you guaranteed tax savings, which could be more than 30%, depending on your income and tax rate.
If you’re maxing out a retirement account, then you’re in a good position to max out an HSA as well. If all or most of your HSA balance is invested in diversified funds, some might argue that it’s better not to spend it.
If you can afford not to tap your HSA, that gives you maximum tax savings. However, if your HSA funds are not invested and are earning no or tiny amounts of interest, you’ll probably come out ahead by spending them on qualified medical expenses. However, knowing which option would save the most depends on several variables.
On one hand, spending your HSA gives you guaranteed tax savings, which could be more than 30%, depending on your income and tax rate. Finding an investment to beat that would be difficult.
On the other hand, letting your HSA stay invested for decades could end up being more valuable with compounding interest. This depends on the return you get and how long the account remains invested.
Here’s how I use my HSA: I make monthly contributions in amounts that max out the account by the end of the year. Every month, I sweep amounts that exceed $1,000 into growth-oriented investments.
My husband and I use our HSA funds to pay qualified expenses as we go. Paying medical costs using pretax money is an immediate benefit that I don’t believe I could beat by leaving the account untapped. I can’t know which option is right for you, but the good news is that any way you choose to use an HSA saves money and is a huge win.
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