Should You Max Out Your HSA Contributions?
Financial planners know something you may not—when you max out your HSA, some powerful tax advantages follow. Did you know that your health savings account can be a significant part of your retirement nest egg?
What Is an HSA?
A health savings account—or HSA—is an account specifically for paying healthcare costs. Because of the tax advantages that come with your HSA, contributing to and using the account to pay for qualified medical expenses gives you a significant discount on your healthcare costs.
Do I Qualify?
Not everybody qualifies for an HSA. The main qualification is that you must be covered by a High Deductible Health Plan (HDHP). As the name implies, HDHPs require you to pay a significant portion of your healthcare costs upfront before insurance kicks in. To qualify for an HSA the plan must require you to pay at least the first $1,400 ($2,800 for family plans) and a maximum of $6,900. ($13,800 for families) for 2020.
Warning: To qualify for an HSA, you have to pay the above amounts before insurance pays anything. That means you’re responsible for the insurance-adjusted costs of doctor visits. If they charge the insurance company $150 for a visit, you have to pay it until you pay your deductible. But remember, you can use your HSA balance to pay those costs.
If you can afford to shoulder those portions of your medical care upfront, HDHPs often cost less than other health insurance plans and probably qualify for an HSA.
Are You in Good Health?
The main purpose of your HSA is for paying for medical care but if you use your entire balance each year, you can’t take advantage of the benefits that come from holding a balance long-term. For that reason, don’t think of your health savings account as an investment vehicle if you deplete the balance each year.
Why Max Out Your HSA?
The tax benefits are so good that some financial planners say to max out your HSA before contributing to an IRA. Here’s why:
- You get a tax deduction when you contribute funds. As of 2020, you can write off up to $3,550 of your contributions if you’re single or $7,100 for family plans.
- You don’t pay any taxes upon withdrawal as long as you use the money to pay qualified medical expenses or qualified health insurance premiums if you’re over the age of 65.
With an IRA, you get one or the other; you get the tax advantages when you contribute or when you withdrawal but not both. With an HSA, you get the tax benefits on both sides.
As of 2020, you can contribute a maximum of $3,550 or $7,100 for families. (The same limits that qualify for a tax deduction.) Like other retirement accounts, these limits adjust based on inflation rates. Once you reach the maximum, redirect contributions to an IRA, 401(k), or another retirement account. Also, just like other retirement accounts, you’re allowed an extra $1,000 in catch up contributions once you reach age 55.
Just like all tax-advantaged retirement accounts, if you use the money for something outside of its purpose, the IRS will hit you with some pretty hefty penalties. Your HSA funds must be used for qualified medical expenses. If you use the money for anything else, you pay ordinary income taxes on the withdrawal plus a 20 percent penalty. Some quick calculations show that you could pay nearly 50 percent or more in taxes and penalties if you don’t use the money for its intended purpose.
Once you reach age 65, things change slightly. You can use the funds for things other than medical expenses but you will only pay ordinary income tax.
If you’re in good health or can pay those medical costs out of pocket until you reach your deductible, you can think of it as adding an extra $3,550 or $7,100 to your Roth IRA yearly maximum. That’s a great deal!
How It’s Invested
Before using your HSA as an investment vehicle, do some investigating. If your employer offers you the HDHP with a health savings account, first ask about the company who will hold the HSA funds. If it’s nothing more than a true savings account, you won’t get much benefit from maxing it out since the money isn’t being invested. Many companies allow you to invest the funds into something more aggressive than a traditional savings account. If your HSA comes with investment options, that’s where the HSA becomes a vehicle for wealth building.
Don’t Forget About It
Although you’re eligible for an HSA if you’re self-employed, most people get the account through their employer. Just like a 401(k), when you leave your current company, that account is yours to take with you. As long as you remain enrolled in an HDHP you can contribute to your HSA. Don’t forget about your account and collect all the information about it from your human resources department if you’ve had little contact with it in the past.
Some Simple Math
To show you the power of an HSA, consider this: For the sake of simple math, let’s say that the maximum contribution never went up and you contributed the maximum each year for 20 years and earned a 4 percent rate of return.
We’ll use a very conservative return rate because you will have some years where you have to withdraw some funds for medical expenses. Using these numbers, you would have a balance of almost $106,000 that is completely tax-free if used on qualified medical expenses.
As you age your medical expenses will become a larger part of your monthly budget. Having this much money set aside for expenses that could also include long-term care later in life frees up your other retirement funds for things more discretionary.
Don’t view your health savings account as something to zero out before the end of each year. This is a valuable tool in your retirement savings arsenal.