My Comments: This is #6 in a series of 6 blog posts about Heath Savings Accounts, or HSAs. They are a potential game changer for those of you who qualify in that they have tax advantages and can suplement whatever else you are doing to set aside money for retirement.
The writer of the article below is a physician who has built an incredible following with a site called the White Coat Investor. I’ve been following him for years and consider his advice remarkably good. I encourage you to read these words and to follow his consistently helpful advice, regardless of whether you wear a white coat or not.
by Jim Dahle \ Nov 5, 2018
Health Savings Accounts (HSAs) were signed into law at the end of 2003 as part of the Medicare Prescription Drug, Improvement, and Modernization Act. These accounts are a dramatic improvement over the older Medical Savings Accounts (which were limited to the self-employed and small businesses), Health Reimbursement Arrangements (where the employer owns the account), and Flexible Spending Accounts (which are “use-lose” accounts that do not roll over year to year.) Many investors do not realize their HSA is, in many ways, their best investing account. It is particularly useful for the high income professional.
# 1 A Healthy Family
If none of the members of your family suffer from an expensive, chronic medical condition, chances are good that a High-Deductible Health insurance Plan (HDHP) is the right plan for you due to its lower premiums. In order to have a HSA, you must only be covered under a HDHP. You cannot be covered under another health insurance plan or a health-sharing plan. In 2018, an individual covered only by a HDHP may contribute $3,450 ($3,500 in 2019) to a HSA. A family (defined as two members, not necessarily both spouses) may contribute $6,900 ($7,000 in 2019.) If one member of the family is 55 or older, there is an additional $1,000 “catch-up” contribution permitted.
# 2 A High Income
HSAs are particularly useful for high income professionals for several reasons. First, they are likely to have the discretionary income to actually make a contribution to an HSA each year. Second, they are often able to cash flow the deductibles and co-pays related to their health care expenses, allowing them to benefit most from a High Deductible Health Plan. Finally, and most importantly, they benefit the most from making the contributions due to their high marginal tax rates. When a family contributes $6,900 to a HSA, that money is no longer subject to federal or state income taxes. If your combined marginal tax rate is 45%, that deduction is the equivalent of receiving a gift of $3,105 for your birthday, to spend on whatever you like. In addition, if the contributions are taken out of your paycheck by your employer, they are not subject to payroll taxes like Social Security and Medicare either.
# 3 Ability to Invest
A lot of people do not realize they can invest their HSAs. Perhaps this is because the default option is usually a low-yield savings account. However, just like a 401(k) or Roth IRA, money in a HSA can be invested in mutual funds such as broadly diversified, low-cost index mutual funds. If the HSA selected by your employer does not permit this, you can rollover your HSA dollars to one that does once per year. In fact, you never have to use the HSA selected by your employer, although you will give up a possible payroll tax deduction if you do not. This permits the HSA to earn a higher rate of rate and the fact that HSA dollars roll over year to year allows you to invest for the long term. Just like a 401(k) or a Roth IRA, a HSA also shields your investment return from the tax drag of long-term capital gains and dividend related taxes.
# 4 Tax-free Withdrawals
Withdrawals from a HSA, so long as they are used to pay for health care expenses (including Medicare premiums). If used this way, HSA dollars are “triple-tax-free”, since you received a deduction when you contributed them, they were sheltered from taxation while they grew in the account, and they were withdrawn tax-free. A HSA is the only triple-tax-free investing account available to you, so in this respect, it is your best investing account. While HSA dollars can be used for ongoing health care expenses, the account really shines when used to pay for health care expenses decades from now, after the money has had time for compound interest to work its magic on the investments in the account.
# 5 A Stealth IRA
Some people worry about contributing too much to a HSA, because they worry they will not be able to spend it all on health care. However, this fear comes from a misunderstanding of HSA rules. Once you turn 65, you can make withdrawals from your HSA and spend the money on anything you like without having to pay the normal 20% penalty. You will have to pay taxes at your ordinary marginal income tax rate, of course. However, in this respect, a HSA is no different from your 401(k). It is still “double-tax-free,” and thus functions as a “Stealth IRA.” Although it is always better to spend HSA dollars on health care, you should have no fear of overfunding the account.
# 6 The Saving Receipts Strategy
While HSA dollars must be spent on health care in order to be withdrawn tax-free, there is no requirement under current law that the withdrawals be taken in the same year the health care is purchased. Thus, some investors have elected to save their receipts to allow for future tax-free withdrawals from the account. This introduces a major hassle of having to keep track of the receipts in the event of audit, and the receipts are not adjusted upward for inflation. There is also some legislative/regulatory risk there that the rules could be changed in the future. That hassle and risk must be weighed against the benefit of ongoing tax drag protection to decide whether or not to pursue this strategy.
# 7 Mandatory Spending
HSA dollars are best spent by the contributor and spouse during life as the HSA rules do not provide significant estate planning benefits. If inherited by your spouse, the account remains a HSA. If inherited by anyone else, every dollar in the HSA becomes fully taxable income to your heir in the year of your death.
Unlike most retirement accounts, HSAs do not enjoy particularly robust asset protection benefits. Although case law is far from settled, HSA dollars are generally included in your bankruptcy estate. A few states, however, do provide an exemption for HSAs.
Since the estate planning and asset protection benefits of HSAs are weak, these accounts are best spent during your lifetime. Given the rapid rise in health care costs, that should not be too difficult for most.
In many respects, Health Savings Accounts are the best investment accounts available to an investor and perhaps the first place to invest each year. HSAs have superior tax protection features compared to any other investing account including their “triple-tax-free” nature, the ability to withdraw the money after 65 for any purpose penalty-free, and the ability to delay withdrawals while saving receipts. If you are using a HDHP, be sure to take advantage of investing in a HSA.
James M. Dahle, MD is the author of The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing, not an accountant, attorney, or financial advisor.