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Health Savings Accounts (HSAs) are my favorite investing account due to their “triple tax-free” tax treatment. You get a deduction for the contribution, it grows in a tax-protected way like your retirement accounts, and it comes out tax-free if you spend the withdrawal on healthcare. Our HSA is the first account we fund every year, and since we've been doing that since 2010, investing it aggressively and only recently spending from it, our HSA is worth more than a quarter million dollars.

Like an overfunded 529, this is a good problem to have. At its worst, 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), earning the HSA its nickname “The Stealth IRA.”

However, I keep running into people who don't know about all of the ins and outs of HSAs, so today, I'd like to cover some of the most frequent misunderstandings about HSAs.

#1 HDHPs Are Not HSAs

Lots of people confuse HSAs for High Deductible Health Plans (HDHP). They are not the same thing. An HSA is an investing account. An HDHP is an insurance policy. It's best to keep them separate in your mind. You are allowed to contribute to an HSA if your only health insurance policy is an HDHP. Whether an HDHP is right for you and, if applicable, your family is a question that is not easily answered. I used to tell people a rule of thumb that if you're a high healthcare consumer, you shouldn't use an 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 run the numbers yourself.

I've seen people with HDHPs that actually cost more than a non-HDHP. I've seen people with HDHPs that offer better coverage than a non-HDHP. Once you add in the tax benefits of a fully funded HSA, an HDHP can be a better option even for someone who hits their max out-of-pocket payment every 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 are not stuck leaving your HSA dollars in a low-interest-rate savings account. You can invest HSA dollars into 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 everything above and beyond a certain amount can be invested. Remember that HSAs are not Flexible Spending Accounts (FSAs). FSAs are use-it-or-lose-it. Any amount left in your HSA at the end of the year just stays in there for future use.

#3 HSAs Can Be Transferred

Many people fund their HSA via payroll deduction. This saves some payroll taxes, and it may also facilitate an employer match. But you don't HAVE to fund an HSA this way. We simply do a transfer from our bank into our chosen HSA (Fidelity) the first week of January every year. You also don't have to leave the money in your employer's selected HSA. You can roll it over to someplace with lower fees and better investing options. Technically, you can only do a “rollover” (where you take possession of the money in between custodians) once a year, but you can do as many HSA-to-HSA direct transfers a year as you want. You could even do one after every paycheck, but that seems like a pretty major hassle.

#4 HSAs Can Be Used with No HDHP

To contribute to an HSA, it is required that your only health insurance plan be an HDHP. However, that is NOT required to spend your HSA dollars. You can use them after changing to another healthcare plan. You can use them for someone who is not even covered by your health insurance plan as long as they are one of the following people:

  1. You
  2. Your spouse
  3. A dependent you can claim on your taxes (including adult children, parents, and more)
  4. Anyone you could have claimed had they not filed a joint tax return

While health insurance premiums aren't usually an eligible HSA expense, there are some exceptions you should know about:

  1. COBRA premiums
  2. Premiums paid while unemployed
  3. Medicare premiums
  4. Employer-sponsored health coverage once you are retired and over 65
  5. Long-term care insurance premiums

While many of those won't apply to most of us, Medicare premiums are a great way to “finish off” your HSA.

#5 Single People Can Make Family HSA Contributions

This one is really interesting and a quirky loophole of HSA law. If your adult child is not your dependent but is on your family HDHP, they can make a family contribution to their own HSA in addition to your family contribution to your HSA. Pretty cool, right? Also, if you're not married to your partner but you're both covered by a family HDHP offered by one of your employers, you can both make a family contribution to your own HSAs. The size of the contribution is not determined by your family status but by the status of your health insurance plan.

It's a pretty odd manifestation of the “marriage tax penalty.” I wouldn't be surprised to see this loophole eliminated in the future, but that's the way the current law works.

More information here:

7 Reasons an HSA Should Be Your Favorite Investing Account

Beware! An HSA Is Great But . . .

#6 You Don't Have to Take Withdrawals in the Same Year as the Expense

Some people, including us, have used a “saved receipts” strategy, where you pay for healthcare expenses with current cash flow and digitize the receipts for later tax-free HSA withdrawals. You can spend $8,000 from your checking account getting put back together after falling off a mountain in 2024 and pull $8,000 out of your HSA tax-free in 2034. If the IRS audits you, you just show them your receipt. Remember that the ink and paper most receipts are printed on doesn't last long, though. Digitize those suckers if you do this strategy. Should you use this strategy? I'm leaning away from it these days. But you can. Certainly, it is a reasonable way to use an HSA.

#7 HSAs Are Best Spent on Healthcare

Lots of people get super excited about their newfound stealth IRA. However, it still makes sense to spend your HSA dollars on healthcare at some point during your life. The higher your tax bracket, the more it makes sense to use those HSA dollars for healthcare, even if you're spending them as you go along rather than saving receipts. In fact, the hassle factor might argue that this is the best way to use your HSA. If you're like most, there will still be extra to invest most years.

#8 HSAs Are Best Left to Charity

While your heirs will still be grateful if they inherit an HSA, they'd 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 tax-free on healthcare, and it does not get a step up in basis at death like a taxable account. It can't be stretched for a decade like an IRA or Roth IRA. It can't be rolled into anything else like a 401(k) or other employer-provided retirement plan. It is just 100% taxable income at ordinary income tax rates to your heir in the year of your death. Not awesome.

However, if you have charitable desires, an HSA is a GREAT account to leave to charity. You don't pay income taxes on it, your estate doesn't pay estate taxes on it, your heirs don't pay income or inheritance taxes on it, and your favorite charity doesn't pay any taxes on it. Our HSA is almost surely overfunded already, but that's OK because we plan to leave a lot to charity at our death.

 

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 are you using it and why?