Health Savings Accounts (HSAs) are my favorite investment account because of their “triple tax-free” tax treatment. You get a deduction for the contribution, it grows in a tax-sheltered manner like your retirement accounts, and comes out tax-free if you spend the withdrawal on healthcare. Our HSA is the first account we fund each year, and since we’ve been doing so since 2010, investing aggressively and only recently spending money from it, our HSA is worth over a quarter of a million dollars.
Like an overfunded 529, this is a good problem to have. In the worst-case scenario, withdrawals can be made penalty-free (but not tax-free) and spent on anything at age 65. This is really no different from your 401(k), which earns the HSA the nickname “The Stealth IRA.”
However, I keep encountering people who don’t know all the ins and outs of HSAs, so today I want to discuss some of the most common misunderstandings about HSAs.
#1 HDHPs are not HSAs
Many people confuse HSAs with High Deductible Health Plans (HDHP). They are not the same. An HSA is an investment account. An HDHP is an insurance policy. It’s best to keep them separate in your mind. You may contribute to an HSA if your only health insurance is an HDHP. Whether an HDHP is right for you and, if applicable, your family is a question that is not easy to answer. I used to tell people the rule of thumb that if you’re a high healthcare consumer, you shouldn’t use HDHP, but I’ve seen so many exceptions to that rule that I’m not sure it’s useful at all. You just have to enter the numbers yourself.
I’ve seen people with HDHPs that actually cost more than a non-HDHP. I’ve seen people with HDHPs provide better coverage than non-HDHPs. Once you add the tax benefits of a fully funded HSA, an HDHP may be a better option, even for someone who maxes out their own payment each year. Run the numbers for what is available to you from your employer or on the open market in your area.
More information here:
To HSA or not to HSA? It’s a complicated question
Should I Get an HDHP Just to Use an HSA?
#2 HSAs can be invested
That’s right. You’re not stuck leaving your HSA dollars in a low-interest savings account. You can invest HSA dollars in mutual funds just like your 401(k). You may want to leave some of the dollars in cash (and your HSA plan may require you to do so), but anything above a certain amount can be invested. Keep in mind that HSAs are not flexible spending accounts (FSAs). FSAs are use-it-or-lose-it. The amount left in your HSA at the end of the year simply stays there for future use.
#3 HSAs are transferable
Many people finance their HSA through payroll deductions. This saves part of the payroll tax and makes an employer match possible. But you don’t have to fund an HSA this way. We simply make a transfer from our bank to our chosen HSA (Fidelity) the first week of January each year. You also don’t have to leave the money in your employer’s selected HSA. You can move it somewhere else with lower costs and better investment options. Technically, you can only do a “rollover” (where you take possession of the money between custodians) once a year, but you can make as many direct HSA-to-HSA transfers per year as you want. You could even do one after every paycheck, but that seems like a pretty big hassle.
#4 HSAs can be used without HDHP
Contributing to an HSA requires that your only health insurance be an HDHP. However, that is NOT required to spend your HSA dollars. You can use them after you have switched to another health insurance policy. You can use them for someone who is not even covered by your health insurance, as long as it is one of the following people:
- You
- Your husband
- A dependent you can claim on your taxes (including adult children, parents, and more)
- Anyone you could have claimed if they hadn’t filed a joint tax return
Although health insurance premiums are generally not eligible for HSA spending, there are some exceptions to keep in mind:
- COBRA premiums
- Premiums paid during unemployment
- Medicare premiums
- Employer-sponsored health coverage once you retire and are over age 65
- Long-term care insurance premiums
While many of these won’t apply to most of us, Medicare premiums are a great way to “round out” your HSA.
#5 Singles can make HSA contributions to their families
This one is really interesting and a quirky loophole in HSA law. If your adult child is not dependent on you but is dependent on your family’s HDHP, he or she can make a family contribution to his or her own HSA in addition to your family contribution to your HSA. Pretty cool, right? If you are not married to your spouse, but are both covered by a family HDHP offered by one of your employers, you can both make a family contribution to your own HSAs. The amount of the contribution is not determined by your family situation, but by the status of your health insurance.
It’s a rather strange expression of the “marriage tax penalty.” I wouldn’t be surprised if this loophole is eliminated in the future, but that’s the way the current law works.
More information here:
7 Reasons Why an HSA Should Be Your Investment Account of Choice
Look after! An HSA is great, but. . .
#6 You don’t have to make withdrawals in the same year as the expenses
Some people, including us, have used a “saved receipts” strategy, where you pay for healthcare costs with current cash flow and digitize the receipts for later tax-free HSA withdrawals. You can spend $8,000 from your checking account to get back together after falling off a mountain in 2024, and take $8,000 out of your HSA tax-free in 2034. If the IRS audits you, just show them your receipt. Keep in mind that the ink and paper on which most receipts are printed do not last long. Digitize those suckers if you follow this strategy. Should you use this strategy? I’m leaning away from it these days. But that’s possible. It’s certainly a reasonable way to use an HSA.
#7 HSAs are best spent on healthcare
A lot of people are getting super excited about their new stealth IRA. However, it still makes sense to spend your HSA dollars on health care at some point in your life. The higher your tax bracket, the more sense it makes to use those HSA dollars for health care, even if you spend them along the way instead of saving receipts. The hassle factor might even argue that this is the best way to use your HSA. If you’re like most, there will be additional investment to make most years.
#8 HSAs are best left to charity
While your heirs will still be grateful if they inherit an HSA, they would all rather inherit something else of equal value. An HSA is actually the worst possible account to inherit. Once you die, it is no longer an HSA. Your heir can’t spend it on health care tax-free, and it won’t get a step-up in basis upon death like a taxable account would. It cannot be stretched for ten years like an IRA or Roth IRA. It cannot be rolled into anything else, such as a 401(k) or other employer-provided retirement plan. It is only 100% taxable income at normal income tax rates for your heir in the year of your death. Not great.
However, if you have charitable needs, an HSA is a GREAT account to leave to charity. You don’t pay income tax on it, your estate doesn’t pay inheritance tax on it, your heirs don’t pay income or inheritance tax on it and your favorite charity doesn’t pay tax on it. Our HSA is almost certainly already overfunded, but that’s OK because we plan to leave a lot to charity when we die.
HSAs are a pretty cool niche investment account. Learn the rules so you can maximize the benefits.
What do you think? Do you use an HSA? How do you use it and why?
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