Health Savings Account: What is it and is it right for you?

The holy grail of tax advantaged accounts: Health Savings Account a.k.a. the HSA. It’s often touted as one of the best tax-advantaged accounts out there, and some may even say, "Everyone should have one!" Unsurprisingly, as with most things in personal finance, it’s not quite that straightforward. 

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This article will walk through some of the very real and legitimate benefits of the HSA, the equally real and potential downsides of the HSA, and what to consider when deciding if one is right for you and your situation. 

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What is a Health Savings Account?

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An HSA is a tax-advantaged savings and investment account designed to help individuals save money specifically for healthcare expenses. It must be paired with a high-deductible health plan (HDHP). The funds in the account can be used to pay for qualified medical expenses, such as doctor visits or prescriptions. 

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As with most tax-advantaged accounts (e.g., IRA, 401(k), 403(b), etc.), the IRS has imposed limits on how much one can contribute each year to their HSA. For 2024, these limits are: 

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• $4,150 for individuals
•  $8,300 for families
• $1,000 catch-up contribution for those 55+ 

These amounts are adjusted each year for inflation.

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Reasons to consider an HSA

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As mentioned earlier, all the hubbub is coming from somewhere. The HSA can be a very powerful addition to one’s personal finances. Here are some of the major benefits of having this account.

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Triple Tax Advantage

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You may be familiar with the tax benefits of a traditional IRA, traditional 401(k), Roth IRA, or Roth 401(k). Well, the HSA does it all! 

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1. Tax deductible contributions: Money you put into an HSA reduces your taxable income for the year. If contributions are taken directly from your paycheck, it can even lower your Social Security and Medicare taxes, which is something traditional retirement accounts can’t do.

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2. Tax free growth: Like a 401(k) or IRA, the contributions grow tax-free. No taxes are due on the earnings while the money is in the account.

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3. Tax free withdrawals: As long as the money is used for qualified medical expenses, withdrawals are also tax-free, much like a Roth account. For traditional accounts, you would generally pay income taxes on any withdrawals.

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This is where the term “triple-tax advantage” comes from and it can be very powerful especially when given time to grow over many years due to the effect of compounding. 

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Flexibility

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I love flexibility and the HSA provides an abundance of it. 

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1. Roll it over: HSAs allow you to carry over unspent funds from year to year. So, whether you expect to be able to use the HSA this year or not may be a moot point since it can always be used in the future should you EVER need medical care that is a qualified medical expense.

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2. Invest it: Funds in an HSA can be invested in stocks, bonds, or mutual funds, allowing the account to grow similarly to any other investment account (but with the tax-advantages discussed earlier). This can create a significant nest egg for healthcare expenses in retirement after allowing compounding interest to do its thing.

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3. Portability: The account is yours to keep, so you can take it with you even if you change jobs or retire just like a 401(k).

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4. No reimbursement deadline: You can reimburse yourself for medical expenses incurred years ago, as long as the HSA was open at the time and you have records of the qualified medical expense. This allows you to pay for qualified medical expenses in cash, file the receipt away, and then reimburse yourself years later as needed. This strategy essentially makes the HSA a long-term savings vehicle which you drawdown tax free as needed.

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5. Treat it like a 401(k): Let’s say you navigate your 20s, 30s, 40s, 50s, and first half of your 60s in remarkable health, haven’t had much qualified medical expenses, and have been contributing to an HSA for many years. First, congratulations on taking such good care of your body, mind and soul! That is no small achievement and should be celebrated. After the party, you may be thinking- how do I get all this money out without paying the 20% penalty for taking withdrawals from an HSA fund that are used for non-qualified medical expenses?

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You are in luck! After age 65, HSA funds can be used for non-medical expenses without penalty. Want to go skydiving, put in a backyard pool or buy some fancy clothes? After 65, you can use the money in your HSA to pay for it! Note that these withdrawals will still be subject to income taxes just like a traditional retirement account. If you do have some qualified medical expenses in your later years, then the withdrawals used for those remain tax-free making this an incredibly versatile account.

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Why You Might Want to Skip an HSA 

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Now that we covered the good stuff, let’s talk about some things about the HSA that might get glossed over.

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You would need a High-Deductible Health Plan (HDHP)

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You can’t contribute to an HSA with just any ol’ insurance plan. It specifically needs to be a HDHP (i.e., a healthcare plan with a sufficiently high deductible). For 2024, an HDHP has an annual deductible of at least $1,600 for self-only coverage or $3,200 for family coverage. That means that the insurance company won’t reimburse you until you have medical costs exceeding the deductible amount and that medical costs before reaching that deductible will be paid for “out-of-(your)pocket.” 

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While an HDHP generally has lower monthly premiums when compared to a non-HDHP, having to pay towards a high deductible before insurance will pay anything can be challenging in the face of medical bills if you are not well prepared.

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Penalties for Non-Qualified Expenses

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As mentioned earlier, the withdrawals for non-qualified expenses before age 65 will come at a steep price. You will need to pay income taxes on the withdrawn amount PLUS a 20% penalty. This makes HSAs less flexible than the 401(k) where the early withdrawal penalty is generally 10% for withdrawals pre-59.5.

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Essentially, if contributing to an HSA will put strain on your budget then it may be wise to first build a general emergency fund before contributing money to the HSA.

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Potential Fees

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Similar to other accounts, the fees need to be considered when doing a cost benefit analysis of the HSA. There may be administrative, investment, or maintenance fees that could reduce the overall benefit of having an HSA.

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More Administration / Management

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Each account, strategy, or tool added to a personal finance picture brings with it overhead in terms of time and mental energy spent on managing that thing. The HSA is no exception to this rule.

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1. Investing: While investing HSA funds can be a way to grow the contributions over time, it also comes with risks. You could lose money if the investments perform poorly and managing the investments may be another thing on an ever-growing never-ending to-do list.

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2. Record-Keeping: You must keep receipts and detailed records of your medical expenses to back up the tax-free withdrawals. Failure to properly document can lead to penalties and taxes. Tracking and managing eligible medical expenses can become burdensome over time, especially if you are considering employing the strategy outlined in item #4 of the Flexibility section above.

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Is an HSA right for you?

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If you are considering or even just curious about whether an HSA is right for you. Here are some things to consider in addition to the pros & cons discussed above,

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Compare the HDHP HSA option alongside the non-HDHP option and look at the following aspects.

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1. Total cost: Imagine enrolling into each of these plans and then there is an unforeseen medical emergency that blows right past the out-of-pocket maximum for the year. What would one be paying with their own money? Or put another way, how much will insurance not cover? This is generally referred to as the out-of-pocket maximum. Take this number and add the annual premium to be paid for having that health coverage. How do these totals compare under each option? I find this helpful since it informs the insured what the upper bound is for the costs they are on the hook for in a worst-case scenario. The HDHP may not be worthwhile if there is a big gap between the potential total cost in a worst-case scenario between the two plans.

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2. In-network / out-of-network coverage: If having the HDHP requires you to get new doctors (or keep your current doctors as out-of-network), it may not be worth the trouble of finding doctors that you trust and like (or pay the out-of-network costs) just for the prospect of an HSA. Or it might be. That’s a personal decision that no general advice about who should or shouldn’t have an HSA will be able to answer.

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3. Other healthcare coverage: If you have other non-high deductible health insurance coverage, such as TRICARE or Medicare, then you generally cannot contribute to an HSA. Additionally, you also cannot (generally) contribute to an HSA if you receive healthcare benefits from the VA or IHS within the previous three months. The complexity of keeping track of your VA visits and aligning your timing of HSA contributions can be a headache. However, there may be an exception for veterans with a service-connected disability who receive care from the VA.

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If you have gone through the above checks and the HDHP HSA plan is coming out ahead, I recommend then considering a couple additional items.

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1. Cash flow planning: Can your budget support contributions going into an HSA? If these contributions will put a strain on your budget, the money will probably be more useful towards building a sufficient emergency fund. After building a healthy emergency fund, the question of contributing to an HSA can always be revisited in the following enrollment cycle.

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2. Medical forecasting: Are you planning on starting a family or doing an elective surgery that would be covered by insurance? Even for those who have enjoyed great health till today, it is worth looking to next year to see if there are any predictable large temporary jumps in medical costs such as planning to have a child. If this is the case, then selecting a plan with a lower deductible may be ideal for the time being.

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3. Consider an FSA: I know, I know. I spend all this time talking about HSAs and then at the very end I introduce a completely new account that hasn’t been discussed at all! HSAs are great but an FSA may get the job done just as well or even better in some circumstances. If you expect to have qualified medical expenses in the coming year then an FSA might be a better option since the money is available on day 1 (whereas an HSA is typically funded throughout the year) and you get to pick a plan with a lower deductible than the HDHP option.

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HSAs can be a powerful tool for managing healthcare expenses and utilizing tax advantage accounts, but it is by no means a one-size-fits-all solution. 

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How MyBudgetCoach Can Help

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Hopefully, this article has been educational and helped highlight how to determine if the HSA is right for your situation. Working with a budget coach can help you understand your money, build an emergency fund, create a plan for managing healthcare costs, and determine if there is room to contribute to an HSA.

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Disclaimer: This content does not constitute insurance, legal or tax advice. Consult with a licensed professional for personalized guidance.