Personal healthcare costs are expected to increase an average of 5% annually in the U.S. in the decade ahead. Creating a Healthcare Savings Account (HSA) is one way to have funds available if- and when—you need them.
As a Certified Financial Planner® and EP Wealth Advisor based in California, I routinely walk my clients through the ins and outs of HSAs to help them decide if this savings vehicle makes sense when planning for their financial futures. Here are some common issues we discuss.
What Is an HSA?
An HSA is a tax-advantaged account that is solely designated for qualified medical expenses. These include things like deductibles, copays, coinsurance, and other out-of-pocket costs. Typically, premiums do not qualify.
Any money that you put in your HSA is tax deductible during the year that you contribute to it—lowering your taxable income that same year. And any interest and capital gains you generate on the investments in your HSA (stocks, bonds, mutual funds, etc.) are also tax-free.
This triple tax advantage is the primary differentiator between an HSA and, say, a traditional savings account or brokerage investment account. Currently, the contribution limits for HSAs are $3,600 for a single person and $7,200 a year for a married couple.
What Are the Benefits of an HSA?
I’ve mentioned the tax advantages of an HSA. If you start early enough, you can possibly have a really long “runway” to invest and grow these funds differently than you would for short- or medium-term goals like buying property or sending a child to college.
While you can make regular contributions into your HSA and pull them out as needed, depleting your account significantly by year’s end, there is a more effective way to use these funds if you can.
Unlike flexible savings accounts (FSAs), which have a “use it or lose it” requirement, unspent HSA funds roll over into the next year—and the year after that. If you can manage current medical costs without dipping into your HSA, you have peace of mind knowing these funds are available for your future needs.
Another benefit of an HSA is that you can reimburse yourself later for medical care you obtain throughout the time your HSA is open.
Let’s say you break your leg at age 25 and can afford to pay the immediate medical costs after insurance out of pocket. If you save your receipts and document these costs, you can pay yourself back dollar-for-dollar for that care once you hit age 65. It’s a great way to ensure your HSA funds continue tax-deferred growth.
Are There Any Disadvantages of HSAs to Be Aware Of?
Well, there are definitely some things we consider to make sure an HSA aligns with our clients’ needs and goals.
Required HDHP Participation
The primary drawback is that while you can use HSA funds any time, you must be enrolled in a High Deductible Health Plan (HDHP.) An HDHP combines an HSA with traditional medical coverage. That means higher deductibles and other out-of-pocket costs when you visit your healthcare provider. But at the same time, you’re able to contribute to your HSA. That’s the trade-off.
Low Annual Contribution Limits
Also, as I mentioned, because the annual contribution limit is fairly low, an HSA is a relatively small tax deferral bucket compared to something like a 401K where you can invest significantly more if you have an after-tax option.
Penalties for Non-Qualified Expenses
HSA funds are intended to be used for just that—medical expenses. If you withdraw from your account to pay for non-qualified expenses before you turn 65, the penalty is 20%. Really, the goal is to grow this account over the long term.
May Not Cover All Healthcare Costs
Even if you start early, your HSA may not be enough to cover all of your medical costs. In fact, medical debt is the leading cause of bankruptcy in this country. We don’t recommend that you depend on your HSA as the only source of paying healthcare expenses. Yet it can definitely supplement your savings and health insurance.
Is an HSA Right for Me?
Possibly. Typically, I recommend HSAs for clients in their 20s, 30s, and 40s who are relatively healthy and don’t anticipate having to tap into these funds for medical care for a while. Someone with a chronic illness, for example, doesn’t want to be on an HDHP because they are seeing their providers more frequently and have a lot of deductibles.
If you are younger and in good health, you may have the funds to put as much as possible into an HSA and let it grow throughout your lifetime.
What Happens if HSA Funds Go Unused?
There are three options for HSA funds that go unused after retirement.
First, let’s say your spouse unfortunately passes away with unused HSA funds. The account remains an HSA and is transferred to you tax-free. You can either keep the account intact, or withdraw those funds for medical expenses. It only becomes taxable if you use the funds for non-medical expenses.
The second option is passing HSA funds on to a non-spouse. This is a bit trickier. Say, for instance, you want to leave the balance of your unused HSA to your son. The entire balance is taxable income for the year that it’s inherited. That can be a big hit, especially if the recipient is a high earner.
This is why I don’t recommend HSAs as estate planning tools. They really should be used as intended—to offset the costs of medical care. The third option is to donate it to a charity or other non-person entity listed as a beneficiary on your estate. In this case, it maintains its tax-free status.
HSAs can be a tool to tackle the rising costs of healthcare. But they should be used strategically, in conjunction with other investment tools for retirement planning. Call or connect with EP Wealth online to find an advisor in your area.
