HSAs: The Triple Tax Advantaged Investment Account

July 26, 2022  | By Manisha Gupta

Although the Health Savings Account (HSA) was created as part of the Medicare Modernization Act in 2003, we field questions almost daily from clients who don’t understand what an HSA account is or how to efficiently use it.

During open enrollment periods, you may be faced with the dilemma of whether to sign up for the high deductible health care plan (HDHP) with an HSA option, or stay with your current plan.  Like most situations when you are pressed for time to make a decision, it’s often easier to stay with the known option and delay the research for a later time.

After helping dozens of families navigate HSAs over the past decade, we’ve created a framework that we find is useful for these decisions.  

What is a Health Savings Account?

Let’s begin with some basic understanding of a Health Savings Account. A health savings account (HSA) lets you set aside money on a pre-tax basis to pay for qualified medical expenses, if you are enrolled in an HDHP at work or in the ACA Marketplace. HDHPs are paired with a higher deductible than a traditional plan such as a PPO or HMO; the deductibles can be thousands of dollars more.

The untaxed contributions you deposit in the account can be used to pay for deductibles, copayments, coinsurance, and other select expenses. And, many employers will make a matching contribution to the HSA on your behalf, which is not considered taxable compensation. 

Tax benefit trifecta

We especially love HSA accounts for long-term investing because it is the only type of investment account that offers a unique “triple tax advantage.” The contributions are:

1. Tax deductible when you put the money into the account
2. Earnings and interest grow tax free 
3. Withdrawals are tax-free if used for medical purposes… and then after age 65, you can withdraw the money for any reason!*

*(Although it will be subject to regular income tax. You can avoid paying taxes by continuing to use the funds for qualified medical expenses.)

An HSA account is managed by you and stays with you, even if you leave the employer. That means if you start contributing to an HSA now, and continue using HSA accounts at future employers as your career progresses, you can invest that money for 30-40 years.

Expenses that qualify for a tax-free withdrawal 

The definition of qualified medical expenses is very broad and covers most medical expenses, from bandages to prescription drug payments, eye exam to eye surgery. A complete list of qualified medical expenses can be found in IRS publication 502.

In addition to the regular medical expenses, here are a few other expenses that are considered qualified expenses for a HSA distribution:

1. Medicare part B premiums
2. Medicare part D premiums
3. Medicare Advantage premiums (not Medigap)
4. COBRA or health care premiums if are receiving unemployment compensation 
5. Part of your long term care policy premium. This varies by age. For the year 2022, the annual limits are:
   • 40 or under: $450
   • 41-50: $850
   • 51-60: $1,690
   • 61-70: $4,510
   • 71+: $5,640

If you withdraw the money and use it for a non-qualified expense, you are required to pay a 20% penalty in addition to the taxes on the withdrawal. However, if you are over 65, the penalty is waived; you only pay the income tax based on your ordinary income tax bracket. 

Is the HSA a “use it or lose it” account?

Unlike health Flexible Spending Accounts (FSA), funds in HSA accounts have no “use by” expiration date: that is the beauty of HSAs! When working with clients, we usually recommend continually adding to an HSA and not using it until you retire.

Why retirement? Because health care costs in retirement are one of the biggest expenses on a fixed income. A 65-year-old couple retiring this year can expect to spend an average of $315,000 in health care and medical expenses in their retirement, according to a new estimate by Fidelity Investments. That’s 5% higher than last year’s estimate.

No required withdrawals

Even once you reach retirement, there is no required withdrawal amount or age from an HSA account, unlike 401(k) or IRA accounts that have a required minimum distribution (RMD) rule. 

And another notable benefit of HSAs: After you reach the age of 65, there is no penalty on withdrawals for non-medical purposes.  The HSA account at that time will have the same characteristics of a regular IRA, but without the RMD requirement. 

Should you enroll in a plan with the HSA option?

If your employer offers the HDHP with an HSA option and you need to choose between that and another type of plan, such as a PPO or HMO, consider these factors first:

1. If you are in good health overall and don’t incur a lot of medical expenses or prescription costs, then the HDHP/HSA may be an excellent fit.
2. If you have significant positive cash flow and are seeking another tax-optimized investing opportunity beyond your employer retirement account, an HSA/HDHP is one of the best alternatives.
3. HSAs might not make sense if you or a family member, such as a child, has a chronic medical condition, pre-existing health concerns, complex medical needs, or see multiple specialists regularly. In that case, your family is probably better served by a traditional health plan.
4. Are you anticipating a major medical expense or surgery this year? Given the higher cash needs to meet an HDHP deductible, it is important to pay close attention to your cash flow and understand if you can fully cover the deductible for an HDHP plan. 
5. Besides higher deductibles, HSA plans usually have higher annual maximums on total out-of-pocket expenses. For 2022, the maximum out-of-pocket expense is $7,050 for individuals and $14,100 for families. That could be prohibitively expensive for your personal situation.

Don’t forget to invest it!

To fully take advantage of these tax benefits, remember to choose the proper investment options within your HSA investment account after you have made the minimum contributions to fund it and then begin investing.

We frequently see scenarios where clients aren’t aware that they need to proactively direct the investments in their HSA accounts. Consequently, the cash contributions pile up over months, and even years. Focus on creating a diversified portfolio using a few low-cost mutual funds and ETFs with a long-term horizon to age 65 and even beyond.