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Health Savings Accounts: The Sharpest Tax Tool In The Shed?

As an investor, you may be thinking about funding an HSA but are unsure about whether it is a useful financial planning tool. Here are six different scenarios for how an HSA can work for you.

Articles by sherrillstgermain

By Sherrill St. Germain
Financial Columnist, Betterment  |  Published: June 13, 2019

As Health Savings Accounts (HSAs) approach their 16 year birthday, their popularity is growing by leaps and bounds – with good reason.

Like Swiss Army knives, HSAs can be very effective at the job they were designed to do and so much more, with innovative new uses coming to light all the time.

Although not everyone is eligible, HSAs can make a flexible, powerful tax-advantaged addition to many financial plans.

You might say that Health Savings Accounts (HSA) are the Swiss Army knives (SAK) of financial planning tools. Both were originally designed for a particular function, which they still do quite well. What’s more, their unique designs lend them a versatility not found elsewhere in the toolshed. As a result, they have evolved over time into powerful multi-purpose solutions.

A Brief History Of The HSA

Conceived in the 1880’s, the SAK has a hundred year head start on the HSA. Through the ingenuity of myriad users, its most valuable applications may have already come to light. In contrast, the HSA is a mere adolescent whose raw potential has only been glimpsed.

When approved by Congress in 2003, HSAs were intended to serve as an aid to Americans struggling to afford skyrocketing health care costs. The concept was simple: Enroll in a High Deductible Health Plan (HDHP) and contribute to its companion HSA, get a tax deduction. Later in the year, withdraw from the account tax-free as qualified medical expenses occur.

Assuming an HDHP was the right choice for your family, it was a pretty good deal. And it still is.

To reiterate, individuals who only use HSA funds for qualified medical expenses receive a triple tax free benefit:

  1. Tax free growth
  2. Pre-tax contributions
  3. Tax free withdrawal (only for qualified medical expenses)

Here’s a sampling of some of the most powerful and interesting applications for this account.

1. Last Minute Tax Planning Tool

Use Case: The good news? Your new employer awarded you a hefty bonus last year. The bad news? You are going to owe big this year. It’s too late to boost your 401k contribution and you’ve already leveraged all other tax breaks. But wait! You haven’t yet maxed out your HSA last year, so you help ease the pain by making a last minute contribution.

Key Feature: You have until April 15 of the following year to make an HSA contribution for a given year.

Caution! Your tax bill will be lower, but you still have to come up with the cash for that, plus the HSA contribution. Note too that contributions made for prior years up until April 15th can’t be made through payroll. That means the tax break for Social Security and Medicare is lost.

2. Retirement Healthcare Nest Egg

Use Case: You have a handle on today’s medical expenses. It’s projections for healthcare costs in retirement that worry you. So instead of depositing only enough to cover this year’s medical expenses in your HSA’s savings account, you contribute the max. Then you put it in potentially higher earning investments similar to your retirement portfolio. Over time, it grows into a tidy sum for retirement healthcare.

Key Features: 1) HSAs are not “use it or lose it”; balances roll over to the next year ad infinitum. 2) HSA money can be invested.

Caution! Some HSA accounts limit you to savings accounts only, or require you to hold a certain amount in cash before investing. Some offer better investment options and lower fees than others. Choose your provider carefully!

3. Medical Emergency Fund

Use Case: You’d been using your HSA to build a healthcare nest egg as in #2. Then a silly accident left you with shockingly high out-of-pocket expenses. In the past, you might have turned to your emergency fund, credit card, or 401k. Instead, you tap your HSA, leveraging its triple-tax-free nature to cover these costs most efficiently.

Key Feature: It’s your prerogative to change your mind about when to tap your HSA account.

Caution! Only costs that meet IRS standards for qualified medical expenses (see Publication 502) receive full tax benefits. Also, even if your HSA is targeted at retirement, consider keeping a portion in cash. Then if you need it for a medical emergency, you won’t be forced to liquidate volatile assets in a down market.

4. Backup Emergency Fund

Use Case: Same as #3, except the silly accident resulted in more out-of-pocket expenses to your car than to you. This, at a time when your regular emergency fund is already depleted from fixing the leaky roof. You can’t use your HSA savings to pay the auto body shop – not tax- and penalty-free anyway. However, you can be reimbursed by your HSA in 2019 for a 2011 shoulder surgery you paid for with non-HSA funds. Then you can use that cash to cover your fender bender.

Key Features: Same as #3, and… There’s no time limit on when you can be reimbursed for prior qualified expenses.

Caution! Same as #3, and… Be meticulous about HSA recordkeeping. If you can’t produce receipts for reimbursed expenses during an IRS audit, your triple-tax-free benefits could be disallowed, and penalties due.

5. Supplemental Retirement Savings Account

Use Case: You diligently fund and invest your HSA over the years, resulting in a healthy balance at retirement. But lucky you, you got the good genes! As it becomes apparent you won’t need your whole HSA for medical expenses, you decide you’d like to spend it on a yearlong cruise instead. You absolutely can, and it won’t cost you tax-wise any more than withdrawing from your IRA.

Key Feature: At age 65, the penalty for non-qualified HSA withdrawals goes away.

Caution! Although you won’t pay a penalty, you will be subject to taxes on withdrawals used for anything besides qualified medical expenses.

6. Long Term Care Coverage

Use Case: Your family’s history suggests you won’t be one of the lucky ones described in #5. But the cost of long term care (LTC) insurance is inducing serious shock. You can make it more affordable by using triple-tax-free HSA money to pay the premiums. If you’re not eligible or incur LTC costs not covered by insurance, those too can be paid with HSA funds.

Key Feature: LTC insurance premiums and out-of-pocket costs are qualified medical expenses.

Caution! No double-dipping! If you use your HSA for LTC expenses, you can’t also take other LTC-related tax breaks.

Finding Your Edge

The best application for your HSA is a function of your personal situation, needs, and resources. So take time to educate yourself or work with a financial pro to get the most out of it. Then help ensure it stays in optimal working order by periodically monitoring cash levels, fees, investment options, and asset allocation.

And keep a sharp eye out for new laws, products, and usage models. While the HSA is already a valuable addition to any financial toolbox, the history of the Swiss Army knife suggests that its potential has just begun to be tapped.

Any tax information provided by Betterment is not a substitute for the advice of a qualified tax advisor. You should consult with your tax advisor to discuss tax-related concerns.

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