All about HSA accounts, including what it is, how it works, how to contribute to it, and what the benefits are of a Health Savings Account.
According to the latest report from the US Bureau of labor statistics, the average American salary is roughly $49k. And according to the Tax Foundation, an independent tax research firm, the average American pays almost 16% of their gross income in taxes. Based on those numbers, as an average American working 40 years in the workforce before retirement, you would be paying the IRS, over $313k in taxes within your lifetime.
Now that’s a lot, especially if you consider the opportunity cost of what that money could have earned you, had you invested it into the market within those 40 years. Of course, there’s no way to avoid paying the taxes that you owe — but one of the smartest keys to building wealth is to reduce the amount of those taxes that you legally owe to the IRS and one of the best ways to do that is to take advantage of something called an HSA.
Welcome to Daniel’s Brew — where I cover personal finance, investing, and career development topics.
So let’s start off with what an HSA is, exactly.
WHAT IS AN HSA?
HSA stands for Health Savings Account — and it’s a special kind of savings/checking/investment account that you can open up, in which you can contribute money you plan to use for qualified medical expenses. Now, before we get in too deep — in order for you to truly understand how an HSA works, you have to first understand how typical health insurance operates.
You see, the way health insurance is done through your employer is that you typically pay a fee each paycheck to enroll in a health insurance plan and when you have a qualifying medical expense, the insurance company subsidizes a good portion of the payments, as long as you meet their criteria — like your deductible and your out of pocket maximum.
Here is an example of how that works.
This is Amy — she works at ABC corporation. Amy pays $12.00 from each paycheck to participate in the health insurance program that ABC Corp has in partnership with XYZ Health Company. That $12 she pays each paycheck gives her a health insurance plan that has an $800 deductible after which they pay 80% of all expense and a $1000 out of pocket max after which 100% of the expenses are covered.
So let’s say that at the beginning of the year, Amy goes snowboarding and needs to go to the hospital for a minor injury she sustained. Her medical expenses are $500 — which means she has to pay for all of it out of pocket. But notice that her deductible and out of pocket meters go up.
Then a couple of months later, she has a small bicycle accident and visits the hospital once more, for medical treatment. This time, her visit costs her $300, which she again pays for out of pocket. But the good news though is that she just hit her deductible limit, so now, going forward, any future medical expenses will be split between Amy and XYZ Health Company 20/80 respectively.
Now towards the middle of the year, Amy decides to go hiking in the woods and accidentally catches a case of poison ivy. This time her doctor’s visit was $600, but because she has already hit her deductible, she only pays $120 out of pocket and XYZ Health picks up the remaining $480.
Now, it’s been a pretty unlucky year for Amy, so a couple of months later, she gets into a small car accident and has to go to the hospital for some minor back pain. The treatment was $400 in total and with the 20/80 splits, she pays $80 and XYZ Health pays $320.
Now at this point, Amy has also hit her out of pocket maximum. What this means is that any further medical expenses she has for the rest of the year are now 100% covered by XYZ health.
And that’s generally how health insurance works, in most cases.
How does an HSA work?
Now, how does an HSA fit into all of this, you ask?
Good question — how an HSA works, is that it’s a special checking account that you open up, in conjunction with signing up for a regular insurance plan, that you can use to pay for your qualified medical expenses. You see — when you it comes time for you to enroll in your company’s benefits, there will be a section of health insurance options for you to choose from.
Now if your company offers one, then one of those options will be a high deductible insurance plan with an HSA account. You see you still need a regular insurance plan like in the example with Amy earlier — and an HSA account is simply your method of paying for the deductibles and out of pocket expenses in that plan.
So then you might ask — “Ok, well if that’s the case, then what is the difference between setting up this HSA and just simply paying from my current personal checking account? I mean, why would I set up a separate account just for my medical expenses?”
The answer to that question gets to the heart of why an HSA is so valuable. You see — an HSA account is special because it comes with 3 core tax benefits:
- Contributions are Tax-Free. Any money that you contribute into your HSA account is not subject to tax. That’s right — tax free contributions, just like your 401k! Since creating an HSA is typically done as part of your enrollment into your company’s health insurance plan — your contributions to your HSA are usually done through payroll deduction. So when you receive your net paycheck each period, the contributions are taken out pre-tax and sent directly to your HSA account, much like the way your 401k contributions are processed.
- Account Growth is Tax-Free. Secondly, your money also grows within the account tax-free — which means, you don’t have to pay any capital gains tax if the value of your account rises from the amount that you originally put in. Some of you guys might be thinking, “Well, how does the value of your account grow to more than you originally contributed?” Don’t worry, I’ll get to that just a little bit later in the article.
- Withdrawals are Tax-Free. Third, when you withdraw money from the HSA for qualified medical expenses, your distribution is also tax-free! You see — this gives the HSA a triple tax advantage — which makes this type of account one of the most powerful financial vehicles in the investing world.
Additional HSA benefits
In addition to the tax advantages, there are a few other really cool features about HSA.
- HSA Value Never Expires. The money you put into the HSA never expires — it was your money to begin with and it’ll stay your money until you use it. There is never an expiration date or deadline to use these funds. Each year, your balance just rolls over to the next year — unlike something like a flexible savings account.
- Withdraw Like An IRA. Once you hit age 65, you can withdraw your HSA funds for non-medical expenses as well, without a penalty, BUT you do have to pay income tax on the distribution, unless it is a medical expense, in which case it is still tax free.
- Invest Your HSA Balance. And finally, as an answer to the previous question of how your HSA balance grows beyond the original amount you contributed — you are able to invest your unused HSA balance into the stock market, making this an additional tax-advantaged financial planning vehicle.
How this works is that typically, the financial institution that holds your HSA account will offer you a curated set of equity types for you to choose from, like mutual funds or ETFs, etc. You can choose to invest a certain portion of your HSA balance (probably an amount that you are not likely to use soon) and place them into those equities, much like the way you would for your IRAs or 401k. Now, if you happen to need the funds for medical expenses, you’ll have to liquidate your holdings and wait for the cash to settle back into your main HSA sweep account before you can use them — so you’ll want to be very careful about how much of your HSA balance you actually want to invest.
HSA Disadvantages
HSAs sound awesome so far, right? Well, there are some disadvantages to keep in mind as well.
- Need a High Deductible Plan. First, in order to have an HSA account, you have to enroll in a HIGH deductible insurance plan. The IRS defines a high deductible health plan as any plan with a deductible of at least $1,400 for an individual or $2,800 for a family, for the 2020 calendar year. This threshold also changes every year as well.
- Limited Investment Options. Secondly, a downside in the investment process of HSAs is that depending on which financial firm holds your account, you may only have a few investment options to select from — it’s usually not open for you to select just any stock, mutual fund or ETF out there in the market — it’s only what is offered to you from that particular financial institution. The most common HSA providers are Optum bank, HSA bank, Lively, Bank of America, and Fidelity — and of those, Fidelity seems to provide most options for investors to choose from — but you’ll want to do your own research if you’re given a choice to select the provider.
- Contribution Limits. Lastly, there is a contribution limit each calendar year of how much you can put into your HSA. Just like the contribution limits for IRAs and 401k, it changes every year, but as of 2020, it’s $3550 for individuals and $7100 for families.
HSA Tactic for Most Profit
Now let me share with you guys one strategy that some people use to maximize the potential of their HSA benefit.
This is a tactic that some like to call Deferred Expense Distribution and it works in these 3 steps:
- Invest 100% of HSA Balance. First, you invest nearly 100% of your HSA balance into the stock market and chooses to pay for all of your medical expenses out of pocket from your own personal bank accounts. This allows all of your pre-tax HSA contributions to grow throughout the year’s tax-free — basically utilizing tax benefits 1 and 2 that I mentioned before.
- Meticulously Save ALL Receipts. Secondly, you make sure that you meticulously save all receipts of all of the medical expenses that you paid for through your personal bank accounts. You can either save them physically or snap a picture of them and save them digitally — but just make sure you take a good quality picture so that your receipts are fully legible if you decide to go the digital route.
- Submit Receipts Years Later. Lastly, since there is no deadline for you to process your expenses for your qualified medical payments — after many many years have past and your invested HSA balance experiences significant compound growth, you can then submit all of your past medical expense receipts and get reimbursed for those payments at that time.
The merit of this strategy is that you let ALL of your HSA money grow and compound for a much longer period before you take out your distributions — thereby increasing your chances of the balance is a large as possible.
Now — I’ll be honest, I’m one of those people that doesn’t do this. It’s a sound financial growth tactic as it pertains to HSAs but for me, I don’t do it for 2 reasons.
1) I don’t know if I trust myself to hang on to medical expense receipts for 20–30 years. As meticulous as I am, I’m pretty sure I’ll lose a few of them in the course of my lifetime.
2) Secondly, you never know when the rules might change and what if they come out with a time limit for you to claim past expenses — I’m sure they’ll give us a heads up and some grace period to process everything before a new rule like that would take into effect, but you never know…
Plus, it’s a lot of hassle…. 🙂
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So — there you have it, that’s everything you need to know about HSAs to get you started. As you can probably guess — I’m a big fan of HSAs, and I hope after reading this article, you guys are too.
In your investment portfolio, if you don’t have an HSA you’re really missing out. I wasn’t joking when I said it is one of the most powerful investment vehicles out there, due to the triple tax advantage it gives you.
So — my hope is that after reading this, you’ll start your own HSA, if you don’t already have one, and that it’ll help you achieve your financial goals for the future.
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The content here is strictly the opinion of Daniel’s Brew and is for entertainment purposes only. It should not be considered professional financial investment or career advice. Investing and career decisions are personal choices that each individual must make for themselves in accordance with their situation and long term plans. Daniel’s Brew will not be held liable for any outcome as a result of anyone following the opinions provided in this content.
