The Most Underutilized Savings and Investment Account.
More tax-advantaged than 401(K)'s, IRA's, and even life insurance.
Health Savings Accounts ("HSA's") are one of the most under-utilized and under-advertised account vehicles for millennials (as compared to their tax-advantaged friends in IRA's, 401(K)'s, 403(b)'s, etc.). Many millennials are aware of HSA's existence, but do not understand the magnitude of benefits they provide.
So what is an HSA? In simplest terms, they are a tax-advantaged savings account (and potentially investment account) used to pay for qualified medical expenses (or potentially -- keep reading -- a retirement account that acts somewhat like a Traditional IRA). Typically, you contribute to an HSA via an employer payroll deduction (some companies even have a "match" on HSA's like 401(K)'s), but they can be self-set up if your insurance policy is not through your employer. Before I unravel the benefits, let's talk briefly about qualifying to even have an HSA in the first place.
Note: If you read the below and are not sure if you qualify, you can talk to your insurance healthcare provider as to whether or not your plan qualifies you for an HSA or feel free to contact our financial coach at https://www.financiallyforgotten.com/contact.
1) You are not being claimed as a dependent on someone else's current year tax return; and
2) You have a High Deductible Health Plan ("HDHP"). For 2020, this means your plan must meet both the following criteria:
a) Deductible must be above $1,400 (unless on a family plan, which then becomes $2,800)
b) The out-of-pocket maximum (deductible, coinsurance, etc.) must be less than $6,900 (or $13,800 for family plan)
There is one more requirement about not having other disqualifying health coverage, so please see Publication 969 on the IRS website and search phrase "Qualifying for an HSA" and follow the links as appropriate for full guidance on all the criteria.
Keep reading -- this is the meat and potatoes of this post. The benefits! I can almost guarantee you will learn something new. Here we go:
1) You avoid paying all forms of taxes on contributions to your HSA. This includes federal, state (except CA and NJ), and EVEN the 7.65% Social Security/Medicare taxes. In case you didn't know, when you contribute to your 401(K), you pay the 7.65% S.S./Medicare tax...
2) There are no income limitations on contributing to an HSA. Again, in case you didn't know, if you make too much money you can't contribute to a Roth IRA and can’t get a deduction for contributing to a Traditional IRA. Not applicable with HSA's!
3) If you use money in your HSA to pay for qualified medical expenses^^, the withdrawals are TAX-FREE.
^^The definition of "qualified medical expense" by the IRS is a wide door. To give you an idea, contact lenses, pregnancy test kits, and getting a vasectomy all qualify. Seriously, go check out Publication 502 and search for "What Are Medical Expenses?" and then "What Medical Expenses Are Includible?".
4) HSA's not only serve as a savings account for medical expenses, but also as an investment account! Just like your 401(K), your HSA provider will have a list of funds you can invest in. And all that investment growth is TAX-FREE.
At an HSA's best, you NEVER have to pay ANY taxes whatsoever! No taxes when you contribute, no tax on the investment growth, and no tax when you withdraw to pay for medical expenses. Find me a different account that does that! Now here's where it gets interesting. You might be thinking something along the lines of "What if I have way more money in my HSA than I end up needing for medical expenses"? Well remember when I said HSA's can act like a Traditional IRA...
Once you reach age 65, there are no penalties for withdrawing money from your HSA, for any reason! This means you would just have to pay your ordinary income tax rate on the withdrawals ...sounds to me just like a Traditional IRA! Except even better than a Traditional IRA, there are no required minimum distributions ("RMD's") [in case you didn't know, you have to start pulling out money when you're 72 years old with a Traditional IRA].
Are there limitations with an HSA? Sure there are. The primary 2 disadvantages I see are as follows:
1) Lack of investment flexibility compared to IRA's: Similar to your 401(K), your HSA provider will have a select list of funds (most likely mutual funds and target-date funds) you have the ability to invest in (maybe 20 different funds to choose from). Whereas with IRA's, you can invest in virtually any ETF/mutual fund/target date fund/REIT/Options, etc. Although for some individuals, having to choose between thousands of funds is actually a negative compared to only having to choose between 20.
2) Penalties for early withdrawals: If you withdraw HSA funds before you turn 65 AND it's not for a qualified medical expense, the penalty is 20% whereas with IRA's and 401(K)'s, the penalty is only 10% for early withdrawals (and the age limit for pulling money out penalty-free of IRA's and 401(K)'s is 59.5 rather than 65 for HSA’s).
I would argue that HSA's are among one of the best tax-advantaged accounts that exist in the US today. No account is flawless, but the potential benefits of HSA's could arguably outweigh IRA's and 401(K)'s, granted it makes sense to invest in one based on your financial circumstances.
If you as a millennial are wanting to become more educated on HSA’s or investments as a whole, schedule a free 20-minute consultation with a financial coach at https://www.financiallyforgotten.com/contact. We can educate you on investing and the various questions you should be asking yourself at this stage of your life to build a solid foundation for the rest of your life!