MoneyMonday: Understanding Your HSA

Welcome to this workshop, Understanding Your HSA, Strategies for Health and Wealth.

We think of your financial life as unfolding in three stages. The first is Financial Safety with a focus on building a good foundation. Next is Wealth Accumulation where we gather resources for the final stage, Financial Freedom where we have the money resources, we need to do the things that bring joy and fulfillment to our lives. For more on the money stages, check out our Money Milestones course which takes a deep dive into each stage.

This is a Stage 2, Wealth Accumulation Course.

There are many different expenses you’ll need to plan for as you head toward retirement. Among the most significant, however, are healthcare and medical costs. It’s estimated you’ll need nearly $300,000 just to cover these costs in your golden years.

Health savings accounts or HSAs are like personal savings accounts, but the money is used to pay for health care expenses. You take a tax deduction for the dollars you contribute to your HSA. You can then use the money to pay for qualified medical expenses tax-free.

While this may be a new concept for some folks, these accounts have been around since 2003.

But HSAs are not the only type of medical savings account. There are also Health Reimbursement Accounts or HRAs. These accounts are used by employers to reimburse qualified medical expenses paid by employees. There are also Flexible Spending Accounts or FSAs. These accounts are used to save on taxes for qualified expenses that might be medical but may also cover qualified dependent care costs like daycare or summer camp for children. FSAs are “use it or lose it” accounts and money not spent in the year are forfeited.

While this is not intended to be a comprehensive overview of these various health spending accounts, let’s highlight a few key differences.

First, HSAs are owned by you, HRAs and FSAs are part of an employer plan.   To be eligible to open an HSA, you must have a qualifying high-deductible health insurance plan. Only employer contributions are allowed in HRAs, but you and your employer can both contribute to HSAs and FSAs. Only HSAs can be invested. Finally, HSAs must be reported on your tax return.

The real power of an HSA is in its tax benefits. HSAs are triple tax-free… an opportunity you rarely encounter. First, you take a tax deduction for the amount you contribute to your HSA each year. While the dollars are in the accounts, your savings and investments grow tax-sheltered. Finally, withdraws taken for qualified expenses are tax-free.

And, if a triple tax benefit isn’t enough of a benefit, HSAs can also serve a dual purpose when it comes to your retirement planning. In order to be prepared to have the money resources you need to experience a rewarding retirement; you’ll need to plan for adequate retirement income. But you’ll also have healthcare expenses in retirement. A good plan will address both and your HSA savings can provide for retirement income AND healthcare needs.

First, when it comes to healthcare expenses, whether you are still in your working years or enjoying your golden years, HSA withdrawals for qualified medical expenses are always tax-free. That means if you refrain from spending your HSA while you’re working, you’ll have a bucket of tax-free money to pay for doctor visits, medication, and other healthcare costs in retirement.

But another important feature of HSAs is that withdrawals after age 65 are penalty-free and taxed as ordinary income. In other words, an HSA can also be a tax-deferred retirement savings account. While we don’t recommend thinking of your HSA as a primary source of retirement savings, it’s good to know that you can use the account for things other than medical costs.

Since the main purpose of an HSA is to prepare for medical costs, it’s important to know what counts as a qualified medical expense. There are, of course, the obvious things office visits, medication, hospital costs…

There are many other types of qualified expenses too. Things like glasses and contacts, treatments like acupuncture and chiropractic care, hearing aids, and even long-term care insurance premiums are subject to certain limits based on your age.

Once you begin Medicare coverage, which occurs at age 65 for most people, you can use your HSA funds tax-free and penalty-free to pay for Medicare Parts A, B, D, and Medicare HMO premiums.

However, premiums for Medicare supplemental policies, such as Medigap, are not eligible expenses. Assuming you’ve reached age 65, however, you could take a penalty-free HSA distribution to pay these types of premiums, but the distribution would be taxed as ordinary income.

That brings us to the question of how long you can contribute to an HSA. Once you are enrolled in Medicare, you are no longer eligible to make additional contributions to your HSA account. You may continue contributing to your HSA by delaying your enrollment in Medicare coverage but keep in mind that you are automatically enrolled in Medicare Part A when you start your Social Security benefits. Finally, you will be ineligible to make HSA contributions on the first day of the first month that your Medicare coverage begins.

In the early stages of your financial life, you might need to use your HSA as a “money in, money out” type of account. By that I mean, you may spend some or most of what you save during the course of the year.

But, as your financial situation improves, you may begin to think of your HSA as a long-term investment rather than just a healthcare savings account. And, like any other investment account, small monthly savings contributed over long periods of time can really add up.

If you have adequate emergency savings to cover medical expenses without using your HSA funds, you can think about investing to grow this account for your golden years. And like any other investment account, you’ll want to consider your situation when building your HSA investment portfolio.

That means you’ll need to know your appetite for risk which we call your risk tolerance. If you haven’t already taken a risk assessment, you can find a questionnaire in your MyMoneyNav portal. 

You’ll also need to consider the likelihood that you might incur significant medical expenses in the near future and your financial capacity for paying those expenses without tapping into your HSA.

But perhaps most importantly, you’ll need to consider your time horizon or, in other words, how long it might be before you spend the money you are setting aside in your HSA. The longer your time horizon, the more aggressively you can invest.  

And finally, as with all disciplined investing, it’s important to be sure your HSA investment portfolio is diversified across a variety of different types of investments. 

As we head toward the finish line, let’s cover three common questions. First, what happens to your HSA if you change jobs?

The funds in your health savings account are always yours to keep, regardless of your employment status or current insurance coverage. This means that if you change jobs or health plans, you can keep your HSA and spend your funds on qualified medical expenses as usual. However, you’ll need to remember that, in order to make additional contributions, you’ll need to have a qualifying high-deductible health insurance plan.

Next, what can you do if you are not eligible for an HSA? Let’s take one in two parts. First, if you already have an HSA but your situation changes and you are no longer able to make additional contributions, you can still use the money in the account as usual – tax-free, penalty-free for qualified medical expenses or penalty free but subject to income tax after you reach age 65.

Finally, what if you inherit an HSA? Like many investments and savings accounts, choosing a beneficiary is an important step. Understanding what happens to your HSA funds after you die may influence your beneficiary choice.

Let’s step through three common situations: first, if the beneficiary is your spouse, next, if it’s someone other than your spouse and finally if you do not name a beneficiary.

When your beneficiary is a spouse, they become the account owner. While you typically need a high-deductible health plan to own an HSA, spousal beneficiaries are exempt from this rule

They can enjoy the same account perks – tax-free, penalty-free withdrawals for qualified medical expenses. They will also face the same restrictions.

If your spouse is under age 65 and takes withdraws for anything other than qualified medical expenses, they will pay income tax plus a 20% tax penalty.   The 20% tax penalty is eliminated for non-qualified withdrawals after age 65. Finally, transferring HSA ownership to a spouse does not create a taxable event but keep in mind the taxes and penalties that might apply to non-qualified withdrawals.

If the named beneficiary of an HSA is a non-spouse (someone other than the HSA owner's spouse, or an entity), the HSA ceases to be an HSA as of the date of death, and the assets must be paid out to the beneficiary.

The non-spousal beneficiary will be subject to ordinary income taxes. While the distribution is taxable, it is not subject to the additional 20 percent penalty tax for nonqualified distributions. The taxable amount may be reduced by any payments made for the decedent’s qualified medical expenses if paid within one year after death. The non-spouse beneficiary must complete Form 8889 to report the value of the HSA and the amount of any qualified medical expenses of the deceased HSA owner that were paid within one year of death.

If you do not name a beneficiary, the HSA proceeds will be paid to your estate and subject to the appropriate estate taxes. Since estates may pay taxes at a higher rate than an individual, we generally recommend that you avoid leaving your beneficiary boxes blank.

Let’s close with two case studies. First, let’s consider an employee who is in the early stage of their career.   they are 27 years old and earn $60,000 annually. They are in good health and covered by a high-deductible health plan.

Their action plan might be: to open an HSA and contribute monthly. Ideally, divide the annual deductible for your health insurance by 12 and aim to save that much.   inside the HSA, keep an amount equal to that annual deductible in cash, or not invested, in the event you need to make a withdrawal. As you move from year to year, if you are accumulating more than the annual deductible amount in your account, build an investment portfolio for the excess designed for long-term growth. Ideally, while you are contributing to your HSA, also focus on building an adequate emergency savings account and also continue saving in your 401k.

Next, let’s consider an employee who is in the later stage of their career.   they are 50 years old and earn $100,000 annually. They are in good health and covered by a high-deductible health plan.

Their action plan might be: to open an HSA and contribute the maximum allowed annually. Aim to pay any medical expenses incurred during your working years from your bank account so you can invest and grow your HSA to be used for medical expenses in retirement. You might also consider using the HSA to pay for Long Term Care insurance premiums in your retirement as well. Of course, it goes without saying that this late-career employee will still want to focus on having adequate emergency savings and making sure their retirement savings are on track.

That brings our HSA workshop to a close. Like many things money-related this can be a confusing topic. Google is full of advice. So are family and friends. But not all advice matches your situation.