Last night I dreamed I was able to put money into an HSA (Health Savings Account).
Sadly, I woke up and realized I was not eligible. You may not share the same excitement as me about having an HSA, but if you have one you should definitely be excited.
That’s because if used properly, HSAs can be a fantastic way to manage taxes and even prepare for retirement. Here are three major reasons you should get excited about your HSA.
Hands down, the best features of the HSA are its tax benefits. The HSA manages to wrap up all manner of tax perks into one account.
First, when you fund your HSA via a payroll deduction, the deduction comes out of your paycheck before tax—the funds don’t count towards your income, thus reducing your taxable income.
Then, the money grows in the account on a tax-deferred basis, so it can compound without the impacts of taxes reducing your earnings. The more money that you set aside in your HSA, the bigger the account can grow.
Finally, when you use the money for approved medical purposes, the proceeds come out completely tax-free.
Essentially, any money directed to an HSA and subsequently used to cover a medical expense will completely avoid the tax man. You won’t pay a dime in taxes, on either the contribution or the investment earnings! There is not a better tax benefit to be found.
Retirement Health Care Plan
I think of this as the great little secret of the HSA, and possibly one of its greatest features. Since there is no specified time period in which HSA funds can be used (unlike the HSA’s use-it-or-lose-it FSA cousin), you can effectively leave funds in your HSA indefinitely, growing tax-deferred all the while.
What this allows you to do, then, is let your investment earnings accumulate until you retire. At retirement, you will have then created your own “retirement health plan” for yourself, funded by years of HSA contributions and tax-deferred investment earnings. Since some of our biggest expenses in our later years are our medical bills (especially once we’re no longer covered by an employer-based health insurance plan), any little bit that we can do to drive that cost down can make a big difference.
As an added retirement bonus, once you hit retirement age (age 65), you can essentially also use the account as you would a traditional IRA, thus increasing your retirement savings (your distributions won’t be tax-free if you don’t use them for medical expenses, but you won’t incur any penalty above and beyond the regular income taxes that you’ll owe—just the same as an IRA). Remember that non-medical-purpose distributions from an HSA before age 65 will carry a 20% penalty, much like the 10% penalty for premature distributions from retirement accounts.
Therefore, the HSA is a great way to prepare for both future medical expenses and retirement at the same time—it’s like the IRS is allowing you two IRAs!
Medical Emergency Account
Another great way to use the HSA is to use it as emergency fund for major medical issues. After all, the number one cause of bankruptcy in the United States is accumulated medical bills—if you have funds building up in an HSA, that will give you one more resource to protect against financial ruin in the case of a major medical issue.
No one ever plans to be in an accident or have a heart attack, but having a fully-funded HSA will make it a whole lot easier to deal with the bills when something does happen.
Keep in Mind
While the HSA is an amazing investment tool, there are still a few things to keep in mind.
- Fees – like any investment, you need to make sure fees don’t deplete your account.
- Balanced Investments – as with most investments, you’ll want to make sure you have a diversified portfolio in your HSA. Especially given the “emergency fund” nature of the accounts, you probably won’t want to have an aggressive investment tilt in your HSA. That’s also the case if you plan to use a portion (or all) of your HSA funds to cover current-year medical expenses—you don’t want market fluctuations to impact your ability to cover next month’s prescription refills.
- Keep Records – if the IRS decides to audit your HSA, you must be able to show receipts for all relevant medical expenses. An easy way to do this is to put the receipts from your medical expenses with your tax records for the year.
- Contribution Limits – watch your limits for each year. You don’t want to over-contribute and have to pay a penalty. The rules can be tricky on the limits, so always check with your administrator.
- Non-Medical Expenses – if you decide to use the funds for non-medical needs before retirement, there will be a tax on the withdrawal and a 20% penalty.
Using a HSA as a way to reduce your taxes and save for retirement medical expenses alone should be reason to get your HSA open today!