If you’re looking for another way to grow your money more efficiently, this can be a good choice. Here’s what you need to know about the tax benefits of using an HSA.
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What is a Health Savings Account?
In December 2003, President George W. Bush signed legislation that created HSAs. They are tax-advantaged medical savings accounts that allow adults to pay for current healthcare expenses, while also saving for future medical costs.
One of the great things about an HSA is that, unlike its cousin, the Flexible Spending Account, money in your HSA rolls over year-to-year. Plus, it’s also possible to use an HSA provider like Lively to invest a portion of your funds to grow with the help of potentially higher compounding returns. This growth is tax-free when the funds are used for qualified expenses.
Tax Breaks of HSAs
The HSA is a truly tax-free account–as long as you use the funds for approved purposes. Here are the tax benefits you can expect when you contribute to a Health Savings Account:
- Tax deduction: When you contribute to an HSA, you receive a tax deduction. There are no income limits, so your contribution is 100% tax-deductible, no matter how much money you make.
- Tax-free growth: Once the money is in your HSA, it can be withdrawn without taxes later. As long as you use the money for qualified healthcare costs, you don’t even have to pay taxes on your contributions.
An HSA operates similarly to an IRA, except it combines the best of traditional and Roth accounts.
When you’re withdrawing money for qualified medical expenses, you can do so at any time, without penalty or taxes. There are no rules about waiting five years. In fact, many HSA providers, like Lively, offer a debit card that you can use for co-pays and other approved expenses.
While there are no income limits associated with a Health Savings Account, there are some requirements you need to meet in order to take advantage of the tax breaks.
The most important item is that you must have a high-deductible health plan (HDHP) to qualify for an HSA. Check with your employer to see if they have an HDHP option. It’s also possible to find HSA-compatible plans if you shop on your state’s health insurance exchange (these are Affordable Care Act plans).
Once you have an HDHP, it’s possible to open an HSA with a variety of providers. Your employer might even have a way for you to contribute–and could even offer matching contributions. Otherwise, you can open an account with a provider and begin setting aside money.
Some accounts won’t allow you to begin investing your HSA money until your balance reaches $2,000–and then you can only invest the excess. Others, though, like Lively, will allow you to invest immediately. Lively partners with TD Ameritrade for investing. You have to keep the money separate from other investments, and if you need to liquidate shares to pay for eligible costs, you need to allow enough time for your trades to settle.
HSA Contribution Limits
While there aren’t income limits, you do have to pay attention to contribution limits. In 2020, it’s possible to contribute up to $3,550 as an individual or $7,100 if you have family coverage.
Pay attention to the contribution limit, since it can be difficult to manage the paperwork and consequences if you over-contribute.
Realize, too, that you can make previous year contributions up to Tax Day. Similar to an IRA, you can still make 2019 HSA contributions, even though it’s already 2020. When making your contribution, be sure to indicate that it’s a “previous year” contribution so that it doesn’t count against this year’s availability.
HSA Withdrawal Penalties
Even though there’s no such thing as an early withdrawal when you use your funds for eligible healthcare expenses, there are some things to be aware of when you take money from your Health Savings Account.
First of all, if you use your HSA money for non-qualified expenses, you’ll have to pay taxes on the amount. You’ll also be subject to a 10% penalty. It’s important to keep your receipts from healthcare costs if you want to avoid problems if the IRS decides to audit you.
Next, it is possible to withdraw your money for non-medical costs without penalty once you reach age 65. At that point, your HSA can function as a traditional IRA when it comes to non-qualifying expenses. You still have to pay taxes on your withdrawals, since you aren’t using the money for healthcare costs, but you won’t be subject to the 10% penalty. You also won’t ever have to worry about the required minimum distributions (RMDs) that plague traditional IRAs.
How to Use the HSA in Retirement
Some investors like the idea of having another tax-advantaged account they can use for retirement savings. The HSA can work well as part of your retirement plan–as long as you consider the qualified expenses.
There are two main methods for using the HSA in retirement without paying taxes:
- Pay for medical costs out of pocket during your non-retirement years, letting the money grow in your HSA. Save all the receipts. Later, you can reimburse yourself for all of the costs at once, providing you with a nice chunk of tax-free money.
- Let your HSA grow with the help of tax-free investment growth over time. Later, use the account for healthcare expenses in retirement. Your other tax-advantaged accounts can be used for living expenses.
And, of course, if you decide to let your HSA grow over time, it can function as another IRA after you reach age 65, which can help if your other accounts are being drawn down. When making a retirement plan, if you have an HSA, make sure you include it along with your other accounts–including Roth and Traditional IRAs and your Social Security benefits–as you create a comprehensive plan.
Is an HSA for Everyone?
Even though there are some great tax breaks with a Health Savings Account, it’s important to realize that it might not work well for everyone. An HSA works well for those who can afford higher deductibles and who don’t have a lot of chronic health needs.
For example, if you don’t have an emergency fund big enough to cover your deductible, you might end up paying a lot out-of-pocket for your care, on top of paying your premiums. Additionally, there are some situations where you spend any money that goes into your HSA immediately. While you get the tax deduction, you won’t maximize your benefits with tax-free growth.
Carefully run the numbers before you decide on an HSA. It can be a great tool to help you cover your healthcare costs today, as well as grow your total wealth for the future. However, it’s not for everyone, so make sure it meets your needs before you proceed.
Related: Here’s our list of The Best HSA Accounts