It is quite possible that it is smarter to use your HSA dollars for healthcare expenses this year rather than letting them compound for decades and then using them to buy a boat. However, there are 7 guiding principles that should be applied when deciding how to use your HSA.
7 Principles to Guide How to Use Your Health Savings Account
#1 An HSA Is Your Only Triple-Tax-Free Account
When you contribute to an HSA, you get a current-year tax deduction. Your money also grows in a tax-protected manner over the years. Finally, when you pull the money out, as long as you spend it on healthcare, it comes out of the account tax-free. This is better than “double tax-free” 401(k)s and Roth IRAs, so it should be the first investing account you fund each year, after ensuring you receive any available employer match.
#2 An HSA Should Be Allowed to Compound for as Long as Possible
Since the HSA is completely tax-free, it should grow faster than any other account. Thus, it is best to keep the money in that account for as long as possible to allow the maximal compounding of your investments.
#3 HSA Dollars Are Best Spent on Healthcare
HSA dollars can be spent on anything, but if you spend them on non-healthcare expenses prior to age 65, you will not only pay taxes at your marginal tax rate on the entire withdrawal, but you will also pay a 10% penalty. After age 65, that penalty goes away, but you will still have to pay taxes on the withdrawal. Because of these taxes and penalties, it is best to spend HSA dollars on healthcare, but if you must spend it on something else, do so after age 65.
#4 Spend Your HSA Prior to Death
When you and your spouse die, your HSA money becomes fully taxable income to either your estate or, if you have named a beneficiary, to the beneficiary. There is no such thing as a “stretch” HSA. Thus, it is one of the worst types of accounts to inherit. It is far better to inherit a Roth IRA, life insurance, or even a traditional IRA. So try to spend your entire HSA prior to dying and leave something else to your heirs.
#5 HSA Dollars Do Not Have to Be Withdrawn in the Same Year as the Healthcare Expense
Although this rule may change at the whims of Congress, as the law currently stands you do not have to withdraw money from your HSA in the same year you purchase healthcare. Thus if you have a baby at age 35, if you keep your receipts, you can take that HSA money out at 55 and use it to buy a boat — tax and penalty-free.
#6 The Higher Your Tax Rate, the More Beneficial It Is to Use the HSA Instead of Non-Qualified (Taxable) Dollars
If you have a 50% marginal tax rate in your peak earnings years, but only a 30% marginal tax rate in retirement, there is an advantage to using HSA dollars earlier in life. This isn't because it affects health care spending, but because it affects the tax rate at which you can pull the money out if you spend on something besides health care. However, this minor advantage is frequently outweighed by the long-term, tax-free compounding and the ability to invest more aggressively in the HSA due to the longer time horizon.
#7 HSA Dollars Are Not Protected from Creditors
Although there are a few states which exempt Health Savings Account dollars in bankruptcy, (FL, MS, OR, TN, TX, and VA) most states do not. Thus, in the event you are the very rare target of a successful lawsuit with an award beyond your insurance policy limits, it is generally better to have money in a 401(k) or Roth IRA than an HSA.
The Best Way to Use an HSA
The very best way is to use an HSA is to pay for all of your healthcare benefits throughout your life. This allows you to purchase all of your healthcare with pre-tax dollars. However, your future healthcare expenses are completely unknown.
Your HSA may either be much larger than your healthcare expenses, or it may be much smaller than your healthcare expenses. So you have to make an educated guess, and then adjust as you go along in order to arrive at the optimal strategy.
If you think your HSA is larger than future healthcare expenses, be sure to spend it on any available healthcare expense you may have throughout your life. If you reach age 65 and still have a huge HSA, then treat it like a regular old IRA, spending it on any expense with the aim of having the account keel over at the same time or just before you do.
If you think it is smaller than future healthcare expenses, then pay for your current healthcare needs with non-qualified (taxable) dollars, and save that HSA for retirement healthcare expenses. If you are not sure, then spend using taxable dollars now, but keep your receipts.
A Health Savings Account is a great way to reduce your taxes and decrease the after-tax cost of your healthcare. Using it optimally will allow you to maximize your spending, giving, and financial security throughout your life.
How do you use your Health Savings Account? Do you use it for medical expenses now or are you planning to use it on something other than healthcare after age 65? Sound off below!
Principle #6 says: “If you have a 50% marginal tax rate in your peak earnings years, but only a 30% marginal tax rate in retirement, there is an advantage to using HSA dollars earlier in life.”.
Why does tax rate at time of withdrawing for healthcare expenses matter?
If the withdrawal is to pay for healthcare expenses, then it doesn’t matter. Jim was likely referring to the ability to withdraw funds for non-qualified medical expenses, in which case the withdrawals are taxable income, and you would prefer the marginal rate at the time of withdrawal to be less than the marginal rate at the time of the contribution.
I wish I was that smart. But I think I was just wrong originally. But I appreciate you assuming the best about me and your point is certainly valid. I’ll add it to the article and then everyone will think I’m as smart as you.
Because you’re spending pre-tax dollars. The ability to do that is worth more if you have a 50% marginal rate than a 30% marginal rate.
But I think your point is that it’s really about your marginal tax rate at contribution, not the time of spending, and as I think about it now (5 years after writing this article), I think you’re right.
Correct. If you’re spending HSA funds on qualified medical expenses, then your marginal tax rate at the time you make the withdrawal is irrelevant. All else being equal, you would be better off delaying the withdrawal as long as possible in order to give the invested HSA funds time to grow.
The big question that I’ve never heard anyone address is what sort of strategy should be used to draw down HSA funds. Should everyone just spend the funds freely once they retire? There is some merit to that view since HSA accounts are relatively poor to bequeath to someone other than your spouse. But when it comes to qualified medical expenses, an HSA is like a Roth in that there are no taxes upon withdrawal, and many recommend deferring Roth withdrawals for as long as possible and/or only making them to provide income that would otherwise be taxed at a higher marginal rate than you’re already in. The ‘optimal’ approach does not seem to be straightforward.
The ideal is to spend the whole wad in your last 5 years of life. Good luck timing that.
Retirees who are fortunate enough (or else very unfortunate in the event that they die early) to not need to spend their entire HSA during their lifetime should probably consider making a charity the beneficiary rather than their heirs, leaving other assets for their heirs. This avoids the negative tax consequences of inheriting an HSA. Of course, this assumes that the retirees want to leave something behind for charity in the first place.
That’s not a bad idea- spouse first and contingently to charity.
That was my thought except the IRS gets a little picky on things changing hands on the date of a death. It seems you might have a requirement for the owner to file claims. Opps! That could be a substantial stack of receipts. Just figuring. Thanks.
It’s still the owner’s estate filing that last tax return so maybe it’s still okay. But either way, the point is that you should try to spend this thing before you die.
That last month can be very expensive. It wasn’t a philosophical question. For example, that taxable account basis is written up on the date of death, not the last tax year. I would hate to be signing HSA submissions in the last hour (years of expenses). Crass. I would sign before going to hospice if it was significant.
I would think because of the constraints , knowing the expiration would be useful. Especially for the second spouse to pass.
The use it date requirement expiration would make all the planning worthless.
I couldn’t find it. Kind of like having a will or beneficiary.
A good reason to spend as you go I guess.
I have a family HDHP for my wife and I and we are both over 55. Our son is also included on the plan. I understand that the 2019 contribution limit is $7000 plus $1000 catch up for over 55. Does this mean I can contribute $8000 total ($7000 + $1000 for me) or $9000 total ($7000 + $1000 catch up each for my wife and I)?
Yes, if you own two separate HSAs. The $1K catch-up is per HSA. Cool trick eh?
“Never Mix any Kind of Insurance with Investing”
What happened to this mantra? HSA is exactly opposite of it.
However you slice and dice, HSA tax advantage is at the mercy of stock market growth and failure.
it is exactly like a whole/universal life insurance, except used for medical payments.
Just calculate realistically how much Surplus money is left in HSA account at the end of the year Vs if you had kept $7000 in bank to copay every visit under PPO.
What happens when stock market kills your accumulated HSA investments in any year? From where will get money for your 100% upfront copay/visit fees?
Practically it is impossible to keep receipts for next 40 yrs of life to take advantage of so called HSA investments growth. Your doctor/Office/pharmacy may be out of business by that time. IRS can change its mind anytime also.
HDHP is good. Investment side as HSA is bad.
It works only when your Employer contributes entire $7000 /year (as incentive, bonus, good faith etc )to your HSA plan.
Not really. I view the HSA as an investing account, not an insurance account. Choose your insurance plan first and if the right plan for you is a HDHP, then of course use the HSA. But they are two separate decisions/issues.
If you wish to spend from your HSA as you go along, keep 1 year worth of out of pocket max in cash in the account and invest the rest.
While you may think it is impossible to keep receipts, many of us are doing it. We’ll likely get plenty of warning if the IRS changes their mind can withdraw the money at that time.
I totally disagree with your last statement. It’s working for me just fine. I think my HSA made >$15K this year, not counting contributions, thanks to investing it.
The interlock of an HSA and your estate is discussed.
https://www.benstrat.com/downloads/HSA-GPS_HSAs-and-Estates.pdf
One year after death for reimbursement. Well, the value is the date of death and it goes on that year’s tax return. My guess is Turbo Tax and a CPA won’t have a lot of head scratchers figuring out the right strategy.
I don’t know about you, it would seem the exit strategy could be easily defined. I like an exit strategy prior to selecting an investment vehicle.
Owner – 1 yr (pending clarification of Yr of death)
Spouse – transfer
Dependent – open question would they be qualified under the transfered HSA?
Winding down an HSA for taxable income could be double tax. Paid out of taxed income and not claimed and taxed again. To assume heirs will figure that out decades later is probably not the best plan.
It’s clear to me that a stack of receipts (or where on the cloud or electronic file) will probably result in double tax. Blowing it off doesn’t seem prudent if the stealth benefits have value. Kind of reckless, but that’s only an extreme. Building a big balance is incomplete. Close the deal in an efficient way.
Easy to criticize, harder to solve. No offense intended.
Dependents don’t get a transferred HSA. It’s all taxable income to them when you and your spouse die.
I agree it’s important to “close the deal” while alive. This is money that is best spent, not left behind.
Indiana exempts HSA dollars in bankruptcy. See Indiana Code 34-55-10-2(c)(8).
So does WA. I’m sure there are others.
Hello, would digital or scanned receipts in PDF (which can be printed) suffice? I assume we don’t need to keep the original (physical) receipts over the years? Thanks.
I think that would be fine. Frankly, I think it is a very low audit risk issue.
My wife has an HSA qualified plan. It is her and our son. I am separately insured. Can she contribute on the family rate or just the individual?
Family.