A Health Savings Accounts, or HSA, is a powerful account to save for medical expenses, but many people use it in a way that is less than optimal.
Tip 1: Understand the Powerful Tax Advantage of an HSA
What is an HSA?
An HSA is a triple tax advantaged account for people who have qualifying high-deductible health plans (HDHPs). I will explain HDHPs later in this post.
What does triple tax advantaged mean?
- Tax deductible contributions: you receive a tax deduction when you put money into the account
- Tax-free earnings: your earnings grow tax free
- Tax-free withdrawals: your withdrawals are not taxed if used for qualified medical expenses
No other account offers these tax savings. With a traditional 401(k), you make tax deductible contributions, but your withdrawals are taxable as ordinary income. With a Roth IRA, you make after-tax contributions, meaning you receive no tax deduction, but your withdrawals are tax free. With an HSA, you receive the best of both worlds.
You can use the HSA to reimburse yourself for qualified medical expenses without paying tax. One really cool feature of an HSA is reimbursing yourself for medical expenses in past years. You do not need to take a withdrawal in the same year you incur a medical expense.
For example, if your HSA was opened last year and you had a receipt from qualified medical expenses, you could reimburse yourself this year. It’s important to keep receipts because you can reimburse yourself any time in the future.
What are the Benefits of an HSA? An Example:
For example, if you put $1,000 into your HSA and you are in the 24% federal tax bracket, you receive a $240 tax deduction. Essentially, it only cost you $760 to put $1,000 into the account.
That’s a good deal.
If the account grows to $1,200 the following year, you do not need to pay taxes on the earnings.
That’s a good deal, too.
If the account grows to $5,000 in the future, you can pay for qualified medical expenses and pay zero tax.
That’s an even better deal.
It cost you $760 to put $1,000 into an account that is now worth $5,000 that can be used for qualified medical expenses tax free.
How would it grow to $5,000?
You can invest your HSA into stocks and bonds. It does not have to sit at the bank earning 0.01%. For example, if you invested the $1,000 and earned 6% over 28 years, you would have a little more than $5,000 you could use tax-free for qualified medical expenses.
Who is Eligible to Contribute to an HSA?
As mentioned earlier, not everyone is eligible to contribute to an HSA. You must meet a specific set of requirements.
The IRS says to qualify for an HSA, you must meet the following requirements:
- You are covered under a high deductible health plan (HDHP), described later, on the first day of the month.
- You have no other health coverage except what is permitted under Other health coverage, later.
- You aren’t enrolled in Medicare.
- You can’t be claimed as a dependent on someone else’s 2019 tax return.
Source: https://www.irs.gov/publications/p969
If you meet these requirements, you can contribute to an HSA.
For some people, they have the option of enrolling in a high deductible health plan (HDHP).
Tip 2: Understand if a High Deductible Health Plan Makes Sense for Your Situation
What is a High Deductible Health Plan?
High deductible health plans are health insurance plans with higher deductibles and generally lower premiums.
For 2020, it is defined as any plan with a deductible of $1,400 or greater for an individual or $2,800 or greater for a family.
The total out-of-pocket expenses also can’t be more than $6,900 for an individual or $13,800 for a family.
Basically, you will pay a lower monthly premium, but be responsible for most of the health care costs before the insurance company pays.
These plans tend to work best for people who are healthy and rarely get sick. As with anything in life, you never know what will happen. You need to be financially prepared to cover the maximum out-of-pocket expenses each year, which can be significant with these types of plans.
I had the option to choose between a Preferred Provider Organization (PPO) and a HDHP. The PPO generally has lower deductibles and higher premiums and fit best for people who use medical care frequently. Since I rarely pay for medical expenses because I generally do an annual physical exam and a dermatology skin check (skin cancer runs in the family), I chose the HDHP. It saves me money and allows me to contribute to an HSA.
You’ll need to crunch the numbers and make a best estimate about what fits best for your individual situation given the premiums, deductible, and maximum out of pocket expense.
I have seen very good PPO plans with low deductibles and low maximum out of pocket expenses. I have seen families spend sizeable amounts on healthcare each year: some knew in advance, others did not. It’s a personal decision you need to weigh carefully.
What are the HSA Contribution Limits?
For 2020, the maximum contributions are $3,550 for an individual and $7,100 for a family. For those age 55 and older, they can contribute an additional $1,000.
My Example
For example, my HSA is at a brick and mortar bank because that’s the location of my employer’s plan, and I receive a payroll tax deduction when I contribute. What is a payroll tax deduction?
It’s the Medicare and Social Security tax, also known as FICA. In 2020, the amounts are listed below. Combined, they are 7.65%.
For Medicare, as an employee, you pay 1.45% on all your earnings. Your employer pays the other 1.45% for a total of 2.9%.
For Social Security, as an employee, you pay 6.2% on your earnings up to $137,700. Your employers pay the other 6.2% for a total of 14.2%.
If you are self-employed, you pay both sides of the taxes.
I could open and contribute to an HSA at another place and still receive an income tax deduction, but I would not receive the payroll tax deduction. There is no way to get those taxes back.
Tip 3: Maximize your HSA Contribution
For example, in 2020 the maximum HSA contributions are $3,550 for individuals and $7,100 for families. If you made contributions outside of your employer’s payroll, you would pay $271.58 (individual) and $543.15 (families) more in payroll taxes. This amount was calculated by multiplying the maximum HSA contribution of $3,550 and $7,100 by 7.65%, the combined payroll taxes in 2020. If you are unsure if you can contribute the maximum amount, understand your budget and cash flow first.
The payroll tax savings are important, but they are only one component. There are situations where it makes sense to contribute to an HSA outside of your employer’s payroll. You need to review the fees, interest rate, and investment options. It’s possible the fees are high enough and interest rate low enough that contributing to an HSA outside of your employer’s payroll makes more sense.
For example, let’s assume you’re an individual with an HSA balance of $30,000. You can stay with your employer plan, which has a fee of $3 per month or $36 annually. It also offers 0.01% interest. In this option, you receive the payroll tax deduction of $271.58.
Alternatively, you can contribute to an HSA outside of payroll. The other HSA charges no monthly fee and offers 1% interest. In this case, you save $36 in monthly fees, earn about $297 more dollars in interest, but miss out on the payroll tax deduction of $271.58. You come out about $61.42 ahead. It’s not a huge difference, but it is important to consider all the variables.
It doesn’t have to be one or the other though. You can have your HSA through your employer and another HSA. This is exactly what I did.
The HSA at the brick and mortar bank is now earning 0.01%. In 2019, the yield was a little higher, but still peanuts. In total, I earned $1.94 in interest in 2019, despite contributing the maximum amount.
That money is not working for me. It hurts me to see money sitting that could be growing tax-free.
Tip 4: Invest your HSA for Long-Term Growth
Instead of spending from my HSA each year for healthcare expenses, I plan to invest it for decades to grow tax-free. For example, if I go to the doctor and need to pay for tests, I will pay for it out of pocket.
I don’t want to touch the HSA. I want to use it as an investment vehicle for long-term growth.
For example, let’s make some simplifying assumptions:
- You currently have $3,550 in an HSA account.
- You contribute $3,550 for the next 10 years and earn 6%.
By the end of the 10 years, you would have a little over $53,000 and you would have only contributed $35,500 to the account. Your investment earnings were about $17,500.
What if you stopped contributing after 10 years and left it invested earning 6% for another 20 years?
It would be worth a little more than $170k.
Your investment earnings are now about $134,500.
The entire $170,000 can be withdrawn tax free for medical expenses in retirement. See the power of compounding?
Although I believe there will likely always be medical expenses to cover, the account can be used differently at age 65. Up until age 65, if you withdraw money from an HSA for non-qualified medical expenses, you pay income tax plus a 20% penalty.
Once you turn 65, you can withdraw funds for non-medical expenses, pay income tax, but avoid the 20% penalty. It’s similar to withdrawals from a Traditional 401(k).
Tip 5: Open a Second HSA if Your Investment Choices are Limited or Expensive
How to Open a Second HSA
Instead of leaving the HSA with where my employer selected, I opened a second HSA where I could invest the funds. I opened an HSA account with Lively.
After researching different HSA options, I was deciding between Fidelity and Lively. Both offer free accounts and the ability to invest. With Fidelity, you invest through Fidelity’s platform. With Lively, you invest through TD Ameritrade’s platform.
I chose Lively because I wanted to try a startup who focused only on HSAs, and I already had an account at TD Ameritrade. With a startup, the technology is usually very intuitive, and that’s exactly what I got with Lively. If you already have accounts at Fidelity, it probably makes sense to open an HSA with them.
After the account was set up, I did a trustee-to-trustee transfer between the brick and mortar bank and Lively. While that was in process, I set up a TD Ameritrade HSA account from Lively’s website. I detail the steps at the bottom of this post.
My plan is to continue using the employer HSA each year because I don’t want to miss the payroll tax deduction. Each year, I will do another trustee-to-trustee transfer from the brick and mortar to Lively and then into TD Ameritrade to invest it.
I could do it more frequently, but the brick and mortar charges me $25 each time I do it, and I don’t love doing paperwork in my personal time.
If you are interested in how to set up an account with Lively, I outline the steps below.
How to Open an HSA Account with Lively
Click on this link: Lively sign up and start walking through the process.
They will check if you are eligible:
Next, they will ask for your personal info, such as name, SSN, date of birth, phone number, etc. They will ask you to review the information and then ask about setting up a debit card.
Next, you’ll fund your account.
I won’t be funding it from my bank account, so I said “Not Now.”
My employer will not be contributing to this HSA account.
This is where I did a trustee-to-trustee transfer.
Lively told me how the transfer would work.
I input my existing HSA provider and HSA account number on the next screen.
When complete, I received the following message.
I needed to sign the trustee transfer form next.
After signing, I received the following message.
I went back to my Lively login and opened a TD Ameritrade Self-Directed Brokerage Account (SDBA).
The link took me to TD Ameritrade’s website, where I input more personal information to open the account. When complete, I had to print my application and mail it to TD Ameritrade.
It took about two weeks for the funds to arrive at Lively. I’ve seen transfers take much longer, so I was happy it only took two weeks. Once the funds arrived, it was time to transfer from Lively to TD Ameritrade.
I went back to Lively and clicked “Transfer Funds”
I selected the amount I want to transfer
After clicking “Transfer funds,” the next screen showed the pending investment transfer.
Once the funds were in TD Ameritrade, I invested them in an exchange traded fund (ETF). I won’t go into what I choose because this post is focused solely on the HSA. There are plenty of other resources to help decide how to invest for long-term growth.
Hopefully you can see the power of an HSA to reduce your taxes and create a tax-free account for your future self.