How to Maximize Your Health Savings Account

Health Savings Accounts (HSAs), or investment accounts specifically designed to save for and cover medical expenses, have gained a lot of attention as of late, due to their unique tax advantages and flexibility. Offering so-called triple tax benefits, HSAs allow for tax-deductible contributions, tax-free growth, and tax-free withdrawals for qualified medical expenses. Let’s break this down a bit to make it more digestible. 

HSAs are distinct among savings or investment accounts because they provide three significant tax benefits: 

1. Tax-Deductible Contributions- Contributions to an HSA are made with pre-tax dollars, reducing your taxable income for the year, like Traditional IRA contributions, and likely saving you on your taxes. (It should be noted that most states allow this deduction, except for a small handful of states). For 2024, the contribution limits are $4,150 for individuals with self-only coverage and $8,300 for those with family coverage. Individuals aged 55 and older can make an additional catch-up contribution of $1,000 annually.
2. Tax-Free Growth- Funds in an HSA can be invested in stocks, bonds, and mutual funds allowing the funds to potentially grow significantly over a long period of time. Dividends, interest, and capital gains are not subject to federal income tax or state tax (in most states), allowing the account to compound without a tax drag. It should be noted that only 7% of HSA accounts are invested according to The Kiplinger Tax Letter (Vol. 99, No.12)!  
3. Tax-Free Withdrawals- Withdrawals from an HSA are tax-free if used to pay for qualified medical expenses. These include a wide range of expenses, such as doctor visits, prescription medications, dental and vision care, certain over-the-counter medications, as well as Medicare premiums. It should be noted that should you withdraw the funds for non-qualified medical expenses there is a 20% tax penalty, in addition to taxes owed on the amount withdrawn, so funds that may be needed for other expenses should not be contributed.

In short, you receive the tax deduction at the front end like a traditional IRA contribution, tax-deferred growth, and tax-free withdrawals similar to a Roth IRA. When compared with the other popular Roth IRA and Traditional IRA accounts, this combines the benefits of both, without some of the drawbacks.  

One of the key advantages of HSAs is their flexibility and ease of use. Unlike other tax-advantaged accounts like IRAs, there is no minimum age requirement for withdrawing tax-free HSA funds, so long as they are used for qualified medical expenses. Additionally, unlike Traditional IRAs or 401ks, there are no Required Minimum Distributions, meaning funds can remain invested and grow tax-free indefinitely. Also, unlike Flexible Spending Accounts (FSAs) which require ongoing maintenance and submissions of receipts, HSA distributions are simple, most can have a debit card attached to the account or you can transfer the funds to your bank account, however, you will need to maintain records of expenses. Finally, unlike FSAs, there is no use it or lose it stipulation. 

Who can contribute to an HSA

To be eligible to contribute to an HSA, you must be enrolled in a high-deductible health plan (HDHP). ¹

1. For 2024, the minimum deductible for an HDHP is $1,600 for self-only coverage and $3,200 for family coverage.  

1. The maximum out-of-pocket expenses for an HDHP (including deductibles, copayments, and other amounts, but not premiums) are $8,050 for self-only coverage and $16,100 for family coverage. 

1. You cannot be enrolled in Medicare. Once you enroll in Medicare (typically at age 65), you can no longer contribute to an HSA. You can continue to use the funds already in your HSA for qualified medical expenses. 

Like many tax benefits, the government is offering a benefit to incentivize people to purchase certain types of health insurance. In this case, the desired outcome is for people to purchase health insurance with more affordable premiums (read, more people covered by insurance), hence the higher deductible. Additionally, it is desired to have a more manageable maximum cost to protect people from purchasing health plans with out-of-pocket costs that they cannot manage, hence the cap on out-of-pocket for the policy to still qualify as a HDHP. 

Between the lower premiums and tax savings, many people will find this to be the most affordable option, especially people with overall good health. Many employers, hoping to reduce healthcare usage and pay lower premiums, encourage HSA-compatible plans by offering annual funding to employees who select HDHPs.    

There are two strategies for utilizing HSAs: 

1. Where you contribute to your HSA each year you are eligible and withdraw funds whenever a qualified medical expense arises. This is the most common use of the HSA, using it simply as a method of getting a tax deduction for your health care costs.
2. Where individuals contribute to their HSA annually and invest the balance, often aggressively if there are many years until they may need the funds and pay for their medical expenses out of pocket. As they age, the accumulated balance can be substantial, providing a significant tax-free resource of funds for covering Medicare premiums and other substantial healthcare costs, including long-term care.

While investing the balances of the HSA and paying for healthcare costs out of pocket can lead to a substantial HSA balance, which is the goal, it also carries a serious potential risk. That is the possibility of accumulating more funds than necessary for medical expenses during the account owner's lifetime. Depending on who the beneficiary of the account is, this may have significant tax consequences. 

1. If the HSA's beneficiary is the account owner's spouse, the HSA can treat as the spouse's account. The spouse can continue to use the funds for qualified medical expenses, maintaining the tax benefits without any requirement to distribute the assets.
2. If the beneficiary is someone other than the spouse, though, the HSA loses its tax-advantaged status, and the entire account value is taxable income to the beneficiary in that year! This sudden influx of income in one year can easily push the beneficiary into an artificially high tax bracket, significantly reducing the value of the legacy.
3. If there is no designated beneficiary, then the account value is included as income on the owner's final tax return. Again, this would cause a significant portion of the HSA to be lost to taxes.

This means that other than upon the passing of the first spouse, any other beneficiary will receive the entire HSA in a lump sum, a possible tax nightmare.  

A powerful strategy to mitigate the tax consequences of a large HSA balance being distributed in such a way is known as the deathbed drawdown. This involves reimbursing oneself for previously unreimbursed medical expenses from all prior years at a later stage in life upon terminal illness. By doing this, the account owner can take distributions and transfer them to a non-HSA account, reducing the HSA balance.  

To be able to use the deathbed drawdown strategy, though, proper recordkeeping is necessary. HSA owners should keep records of any qualified medical expenses paid out of pocket since establishing the HSA. These records will be used to justify these tax-free withdrawals even as many as decades later. 

In summary, a High Deductible Health Plan/Health Savings Account combo can be a powerful tax savings and wealth building tool, especially for younger investors. It can provide for the large medical expenses that often come with aging. However, care should be taken to avoid the sudden distribution and taxation of improper financial planning. Consult with your tax and investment professionals to determine the strategy that best works for you and assist with executing it properly. 

Footnotes:

1. IRS Publication 969 pgs. 3-4