Should I use my HSA for out of pocket health care expenses or use it as a Stealth IRA?


I've written before about the wonderful benefits of a Health Savings Account (HSA.)  If used for health care expenses, it can be a triple tax-free account.  This makes it better than a traditional IRA, a Roth IRA, and a 529 account.  You get an up-front tax deduction just like with a traditional IRA, it grows without the drag of taxes on dividends and capital gains that you see in a taxable account, and if spent on health care, the money isn't taxed when you pull it out of the account either!  As an added bonus, when you past age 59 1/2, it can be used like a traditional IRA to pay living expenses or buy a new car.  Of course, if you don't spend it on health care costs, you do have to pay taxes on the withdrawals at your ordinary tax rate.  But there's a wonderful catch.

The Catch

The IRS doesn't dictate WHEN you spend the money on health care.  Just because you spent money on health care in 2012 doesn't mean you have to pull the money out of the HSA in 2012.  You can pull it out in 2047 for all they care.  All you have to do is keep the receipts.  So you just need to get a new folder for your filing cabinet, mark it health care receipts, and keep track of every dime you spend on health care over the next few decades.  Then, you pull the money and spend it on an around the world cruise.  As long as the cruise costs less than the amount of money you've spent on approved health care expenses out of pocket for the last few decades, the withdrawal is tax and penalty free.

Should You Do It?

With that background, we can move on to the question.  Should you actually do this?  Obviously if you spend less on health care than you contribute to the account that year currently limited to ($3125 single, $6250 married for 2012) you should leave the difference in the account to keep growing.  But why not pay for all your health care costs out of current earnings, and leave the money in the HSA for decades?  Some people have made arguments against doing this, but I think they're pretty weak.  We'll start with the best arguments, and work out way down to the weaker ones.

7 Faulty Arguments To Spend HSA Money Now

1) I don't have the money.

It's obviously better to use your HSA to pay your health care costs than to take out a credit card loan at 20% to do so.  It might even be better than using your emergency fund.  But I don't buy this argument for several reasons.  First, if you have the money to max out an HSA each year, you probably make pretty good money.  Paying a few hundred or even a few thousand for current health care expenses shouldn't be a huge burden.  You can get a high deductible health plan with a deductible as low as $2400 a year (family), that's just $200 bucks a month, on the order of 1% of a typical physician income.  Second, even if you used your emergency fund, if another emergency came up you could always just tap the HSA then.  It's not like the opportunity to use the money ever goes away.  In fact, the more you spend on health care out of pocket, the more of your HSA becomes a tax-free, tax-protected, and possibly asset-protected emergency fund.  Even a brief credit card loan may be worth keeping that money in the account.  If nothing else, you can pull the money out and pay off the loan at any time.  With all the 0% for 15 month offers I get in the mail, it would be hard for me to justify touching the HSA.

2) I am in a higher tax bracket now than in retirement.

You get the tax deduction when you contribute to the HSA, not when you withdraw from it.  It doesn't cost you more in taxes to spend taxable money than it does to spend tax-free money, so why not spend taxable money?  Even if you end up using the HSA as an IRA, you'll almost surely have a lower effective tax rate in retirement than your marginal rate now.

3) I might die with a folder full of receipts.

I don't see any reason your estate can't do the same thing you would do if you were still alive, although I admit it would be a bit of a hassle, and perhaps not even allowed if it wasn't in the same year you died.  For this reason you might want to tap the HSA funds already “spent” on health care expenses relatively early in retirement.

4) I'm not maxing out your tax-protected retirement accounts anyway.

Since this account is triple tax-free, it's better than all your other retirement accounts.  Would you withdraw contributions to a Roth IRA to pay for health care expenses?  Not if you could help it.  It's the same thing we're talking about here.  You should max out your HSA even if you're not maxing out your 401K, since it is more valuable, and it likely has more investing options and lower expenses anyway.

5) My HSA only pays me 1-2%!  I might as well spend it.

Since you're not going to withdraw this HSA money any time soon, you ought to be investing it as aggressively as the rest of your retirement portfolio.  I only keep enough cash in mine to minimize fees.  The rest of the account is 100% stocks.

6) I may NEVER spend this money on health care.

If you are very healthy, or have access to very comprehensive health insurance such as that provided to military retirees, it's possible you'll get to the end of your life and have not spent as much on health care as your HSA contains.  While I'd say that's a wonderful thing, the HSA is still no different than a traditional IRA.  You just have to pay taxes at your current tax rate upon withdrawal.  Even if you die, the HSA becomes your spouse's HSA.  If you have no spouse (or make someone besides the spouse the beneficiary), the beneficiary inherits a fully taxable lump sum.  Trust me, they'll still be happy. If you leave it to your estate, it will be subject to income taxes for your last year of life (and possibly estate taxes if you have enough money.)

7) The IRS might change the rules.  I want to get my tax break now.

8) My HSA has lots of expenses and poor investment choices.It's always hard to combat these types of arguments.  These are the same people who tell you to use a traditional IRA instead of a Roth one- get your tax break while you still can!  But I think you need to not only consider the consequences of these types of tax law changes, but also their probability.  Changes like these are usually grandfathered in.  Sure, the US Government may implode, but are you really going to plan your finances around that possibility?

Move your HSA elsewhere.  Although there is some tax benefit (you save payroll taxes on it) for an employee to have their employer contribute money directly to their HSA, you can usually roll it out within a year to your preferred HSA.  For an independent contractor or partner, I see no reason not to use the best HSA you can find.

Try as I might, I can't think of any reason to use my HSA money any time soon.  But I am stuffing every health care receipt into a folder I plan to keep for decades.  It might even be worth archiving them electronically as well.