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Should I Contribute To An HSA? Thumbnail

Should I Contribute To An HSA?

Are you a high-income earner and targeting an early retirement?

Maxing out an HSA can be a great strategy for people who plan to retire early. But one of the most common mistakes I see people make is they don't use them correctly. Keep reading to learn how to truly maximize the benefits of an HSA so that you can reduce your taxes now, and reduce healthcare costs later.

First Things First. What Exactly Is An HSA?

A health savings account (HSA) is a tax-advantaged account that can be used to cover qualified medical expenses. HSAs are designed to work together with an HSA-eligible high-deductible health plan (HDHP) offered by an employer. Through this employer benefit, you can typically opt into contributing money from each paycheck into an HSA. These contributions live in an account that can be used to pay for qualified medical expenses, like going to the doctor or buying prescriptions.  Employers can also contribute to your HSA as part of the benefit.

The Most Tax-Advantaged Savings Vehicle In Existence:

When used for qualified medical expenses, the money from an HSA is triple tax-advantaged. This means that each year you contribute to one, you can deduct that dollar amount from your taxable income. When you invest money in an HSA, those investments grow tax-deferred, meaning you don't owe any capital gains taxes on that growth. Then on the back end, if you withdraw the money for qualified medical expenses, those withdrawals are completely tax-free.  There is no other type of account that you can invest in that is like this. This is even better than a Roth IRA or backdoor Roth IRA.

Starting at age 65, there is no penalty if you use HSA money for nonmedical expenses. You will have to pay income tax though, similar to pre-tax withdrawals from your 401(k). There is also no "use it or lose it" rule as there is in health flexible spending accounts (FSAs). Funds remain in your account year to year, and any unused funds may be used to pay for future qualified medical expenses.

How To Avoid Common HSA Mistakes And Maximize Their Benefits

The tax advantages of an HSA can help you get the most value out of your earned dollars as a tool for both health expenses and retirement. But you have to use them the right way. 

  • Mistake 1: Leaving your HSA funds in cash: Many people make contributions to their HSA, but forget to actually invest that money. So it doesn't really grow. That eliminates one of the biggest benefits of HSAs which is tax-free growth. Some employers may require that you keep a minimum balance in cash, $1,000 for example, but anything above and beyond that should be invested in the stock market. HSA plans will provide a variety of investment choices that will provide you exposure to the market and give your money the opportunity to grow over the long run. 
  • Mistake 2: Withdrawing from your HSA while you are still working: If you are simply withdrawing each year the same amount you contribute, nothing is left over to compound in the stock market. This again eliminates the benefit of tax-free growth that the HSA provides. What you should do instead, is have a separate high-yield savings account designated specifically for paying out-of-pocket medical costs each year while you are working. You would replenish this as needed each year while at the same time making contributions to your HSA, which you would not be withdrawing from each year. 

Reducing Healthcare Costs In Retirement

Healthcare expenses are among the biggest concerns people have when they retire. This HSA strategy could potentially lead to you retiring with a 6-figure nest egg in your HSA that you can then withdraw from tax-free in retirement.  Some people may think they won't ever be able to spend that much in retirement on out-of-pocket medical expenses. But one of the nice things about an HSA is that in addition to normal out-of-pocket medical expenses such as co-insurance and co-pays, it can also be used to pay for medicare premiums, dental and vision expenses, and long-term care insurance premiums. 

If you are having to withdraw from your tax-deferred 401ks or IRAs to help cover these expenses, that will be considered taxable income. This in turn could lead to you paying higher medicare premiums due to income-related adjustments (IRMAA).  

How do I know if I'm eligible for an HSA?

You're eligible to open and contribute to an HSA if:

  • You're covered by an HSA-eligible health plan on the first of the month
  • You're not covered by an ineligible health plan
  • You're not enrolled in Medicare (be aware of the 6-month look back rule)
  • You cannot be claimed as a dependent on someone else's tax return

What is an HSA-eligible health plan?

For 2023, the IRS defines HSA-eligible plans as high-deductible health plans (HDHPs) with a deductible of at least $1,500 for an individual and $3,000 for families. These health plans must also have an annual out-of-pocket maximum spending amount of no more than $7,500 for an individual and $15,000 for families.

High-deductible health plans could be compelling to those with minimal health expenses. Typically with a high-deductible plan, your insurance premium is lower. You could look at it as instead of paying the insurer every month, you are paying yourself by contributing money to your HSA.