For most of the population, an HSA is simply a savings account for medical expenses that provides some tax benefits. However, this is your best tax savings account possible.
How is this possible?
Well, this is all possible because of the fact that there is no rule stating that you must use your HSA to directly pay for medical expenses or that you must withdraw money from your HSA within a certain amount of time after paying for a medical expense. As long as the qualified medical expense occurred after the HSA was opened, you can withdraw money from the HSA at any time after incurring the expense to reimburse yourself.
When used intelligently, the HSA can potentially provide the best benefits of both a Traditional IRA and a Roth IRA combined. With an HSA, you are not only able to contribute pre-tax dollars, like you can with a 401(k)/403(b)/Traditional IRA, but you can still enjoy the tax-free growth and tax-free distributions that a Roth IRA provides!
That means you could potentially have tax-free contributions in, tax-free growth, and tax-free distributions out!
Max Out Contributions
Decrease your tax burden by contributing the maximum amount to your HSA each year and increase your savings rate by investing the tax savings.
Assuming you are in the 25% tax bracket, maxing out your HSA could save you over $800 in taxes each year.
Payroll Deduction
When you contribute to your HSA via an automatic payroll deduction, you are able to avoid paying FICA taxes (i.e. Social Security and Medicare) on your contributions.
Assuming you max out your HSA, this could result in an additional $248 of savings per year.
Invest
Rather than treat your HSA as a savings account, instead treat it as a retirement account and invest the entire HSA balance in low-cost index funds (note: not all HSA custodians offer low-cost index funds so make sure yours does before opening an account).
Medical Expenses
Rather than use your HSA to pay for medical expenses, instead use your after-tax money so that you can leave your HSA money to grow tax free.
Receipts
Keep track of all your medical receipts so you know how much you are able to withdraw from your HSA.
As you incur qualified medical expenses, you increase the amount that you can withdraw during early retirement (you effectively convert your HSA into an early-retirement Roth IRA over time).
Retirement
Assuming you reach the age of 65 and have not accumulated enough medical receipts to fully liquidate your account, the HSA can be used for ordinary expenses in the same way that a Traditional IRA can be used for any expenses after standard retirement age (note: withdrawals for qualified medical expenses will continue to be tax free but withdrawals for all other expenses will be taxed as income, just as Traditional IRA distributions are taxed).
Extra Tax-Advantaged Account
The HSA is particularly useful for someone like me who maxes out all of the other tax-advantaged accounts available.
Since I’m in the wealth accumulation phase of my journey to financial independence, I try to limit my taxes as much as possible so that I can make as much of my money work for me as I can. The HSA allows me to contribute more of my income to tax-advantaged accounts, which results in a lower income tax burden and a higher savings rate.
Conclusion
By treating your HSA as a retirement account instead of a savings account for health-related expenses, you can use it to further reduce your tax burden during your working years, shelter more of your investment earnings from tax, and potentially provide a source of tax-free income during your early retirement years!
Example
Let’s assume that I only spend $200 a year on medical expenses. It doesn’t make sense to pay a lot of money for a fancy, full-service health insurance plan, since I rarely go to the doctor, so I instead decide to get a cheaper, high-deductible health plan with a lower monthly premium.
Since I have a high-deductible health plan, I am able to open a health savings account so I elect to put $3,000 into the account every year and I invest the account’s money in a total stock market index fund.
Because contributions to the HSA are pre-tax, depositing $3,000 into my HSA decreases my taxable earned income by $3,000.
When I go to the doctor, I can pay for my $200 yearly visit with my HSA debit card or I can pay for it with cash or with another credit or debit card instead. If I pay with my HSA debit card, that money is extracted directly from my HSA and that’s the end of the story. I just used tax-free dollars to pay for the expense and there is nothing else I can do.
If I instead pay with cash or with another card, however, I am able to withdraw that $200 from my HSA and deposit it into my normal checking account at a later time, to pay myself back for the qualified medical expense. The great benefit of having an HSA is that I can decide when to pay myself back. Since I live well below my means and have ample savings, a $200 payment isn’t going to break the bank so there is no rush to get paid back from my HSA. Instead, I am able to leave that $200 in my HSA and can sit back and watch it grow, tax-free, until I decide to withdraw it!
As long as I keep my receipts, I can withdraw the money for qualified medical expenses from my HSA at any time, in a similar way a retired person over age 59.5 can withdraw money from a Roth IRA…tax free!
So at the end of the year, I have saved myself from paying income tax on the $3,000 of income I used to fund the account, I now have $2,800 that is growing in the HSA tax free, and I have another $200 that is in the HSA growing tax free that I can withdraw whenever I want to!
Q&A:
Question: When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?
Answer: An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year.
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