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Having Your Cake & Eating It Too: Health Savings Accounts

There are many things I love about my job as a financial planner, but none more so than being able to sit across the table from clients and hear their stories. Some are young professionals just getting started in their careers, whereas others are empty nesters nearing retirement. Some are entrepreneurs looking to begin their next venture, and others are celebrating anniversaries after being with their company for 20+ years. And while each of these groups may be wildly different from one another, there a few common threads that everyone agrees with: First, they understand the value of working with a professional on their personal finances (or they wouldn’t be meeting with me!). And second, they love the idea of lowering their tax bills. A mentor of mine once quipped that “talking about politics is an easy way to ruin a dinner party but commiserating about taxes is a sure-fire way to bring everyone back together.”

Fortunately, in 2003, the United States Government created a program that met this need and has proven to be one of the most tax-efficient savings options available in the marketplace – the Health Savings Account.

What is an HSA?

A Health Savings Account (HSA) is a tax-sheltered savings account available to those enrolled in high-deductible health plans (HDHP’s). HSA’s are savings vehicles that allow individuals and families to contribute pre-tax dollars to an account, invest their contributions, and when necessary, use those funds to defray higher deductibles and out-of-pocket costs associated with a HDHP. Most importantly, if money does have to be used to cover medical expenses, it can be withdrawn tax-free.

What’s also important to consider is that with an HSA, unlike health flexible spending accounts (FSA’s), investors are not subject to the “use it or lose it” rule. Once contributed to an account, funds can remain invested for as long as you’d like to cover future qualified medical expenses. The 2021 contribution limits to HSA’s are $3,600 for individuals and $7,200 for families, and if you are 55 or older, you may be able to make an additional “catch-up” contribution of up to $1,000 per year.

What are the benefits?

It’s difficult to overstate how powerfully an HSA can change an individual’s potential wealth through the combined effects of tax-deductible contributions, compounded investment savings, and tax-free distributions, otherwise known as the “triple tax benefit.”

In an ordinary tax-advantaged account such as an IRA or 401(k) plan, individuals can pay taxes up front or defer them, but either way taxes will eventually come due. As I often joke with clients, “There’s no getting around it – the government is going to get their money. They question is, ‘Do you want to pay them now or later?'” With HSA accounts, you can bypass this conversation altogether and potentially never pay taxes on this money as both contributions, earnings, and withdrawals (if qualified) are made tax free. These tax benefits alone can lead to higher net-returns than those available from other traditional tax-advantaged accounts.

Another benefit to these accounts is that if there is money saved above and beyond what one might need for qualified medical expenses in retirement, such as long-term care or Medicare, you can also choose to treat your HSA like an ordinary retirement account. Before turning 65, non-qualified withdrawals may be subject to ordinary income taxes and a 20% penalty, but after 65 the penalty is waived. Distributions may still be subject to ordinary income, but in essence an HSA can act as a supplementary retirement account if needed.

How should you use them?

How to best use an HSA largely depends on how much individuals and families can save. If they have enough savings ability, it’s best for them to treat their HSA as a long-term investment vehicle and leave their funds inside their account. In other words, they should pay for current medical expenses out-of-pocket and leave their savings growing in a tax-advantaged manner. For example, I was once working with a client who wanted to take money out to cover the costs associated with a routine dental procedure. However, after explaining to him that the $500 he withdrew today might be worth $1,000 in 10 years or $2,000 when he retires, we determined the more cost-effective solution was to use the money in his bank account earning little to no interest.

So when is it the right time to use the money? If you are like most Americans, health care is expected to be one of your largest expenses in retirement. According to a study conducted by Fidelity Investments, an average retired couple age 65 in 2020 may need an estimated $295,000 saved to cover health care expenses in retirement. Common expenses to consider include bridging the insurance gap to Medicare (for early retirees), covering Medicare premiums, and paying for long-term care. Fortunately, the HSA allows individuals to begin planning for these types of expenses without it coming out of their more traditional forms of savings, such as retirement or taxable accounts, which is why it’s important to start early.

Summary

HSA’s offer a wide range of benefits for individuals and families. Whether it’s in the short-term helping individuals reduce their taxable income or in the long term by covering medical expenses down the road, there are a number of reasons to consider taking advantage of this savings vehicle.

If you or someone you know has questions about HSA’s or planning for healthcare costs in retirement, please don’t hesitate to reach out. I’d be more than happy to assist them!

Sincerely,

Jim

Jim Davis, CFP® | Financial Planner | Mills Wealth Advisors, LLC | 817.416.7300 | jim@millswealthadvisors.com

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