Get a Triple Tax Break With an HSA

HSAs are often misunderstood. Unlike a flexible spending account (FSA), with an HSA you don’t have time limits on when you must spend the money. In fact, there isn’t even a time limit for when you can reimburse yourself for health care costs. Keeping proof of expenditures is all you need. I can even reimburse myself for expenses dating back to 2004. To date, I haven’t reimbursed myself one penny.

Two ways to use an HSA

The first way to use an HSA is to pay for medical expenses with pretax money. While it’s true that medical expenses that are paid directly can be tax-deductible without an HSA, few people benefit from claiming this deduction. That’s because only an amount greater than 7.5 percent of adjusted gross income (AGI) qualifies as an itemized tax deduction. Even if you meet that minimum, you still may not benefit because only 13.7 percent of taxpayers itemize, according to the Tax Foundation. 

But the HSA allows you to pay for medical expenses with pretax money even if you don’t itemize, and you don’t have to meet any minimum expense. You either pay for the medical expense directly from your HSA (such as by using an HSA issued debit card linked to your account) or you get reimbursed through your HSA.

The HSA allows you to have the government subsidize your health care costs via the tax benefit. For example, if you are in the 22-percent marginal tax bracket, a $1,000 expense that insurance doesn’t cover effectively costs $780. As mentioned, if you don’t spend it all this year, you can carry it forward for an unlimited number of years.

The second way to use the HSA — which still gets all of the benefits above — is as a tax-free investment account, similar to a Roth IRA. In fact, nearly 50 percent of people didn’t withdraw from their HSA in any given year, according to the Employee Benefit Research Institute (EBRI). 

This allows you to invest the money for long-term growth and then pull the money out many years (or in my case, decades) later, completely tax-free, as a reimbursement for medical expenses. You get a tax deduction when you contribute to the HSA, and you don’t pay taxes when you withdraw.

Keeping records of expenditures isn’t all that difficult. You can pay for medical expenses with a credit card, and it’s pretty easy to keep track of monthly Medicare premiums, including the dreaded income-related monthly adjustment amount (IRMAA). This means you can invest for the long run, allowing the account to accumulate and growth to compound.

Be aware that when you (and your spouse) pass away, the HSA will be taxed as income to your beneficiaries. That’s perhaps the biggest difference between it and a Roth IRA, for which the beneficiary pays no income tax. 

Summing it all up

If you are using an HSA for the short run, paying for ongoing health care expenses, make sure your HSA account has low fees and use a cash account paying a high interest rate. If you are using it as an investment account, keep good records of qualifying expenditures and use an account that has low fees and attractive low-cost and diversified index funds as options to invest.

A couple is likely to need an average of $296,000 to cover health care expenses in retirement, according to EBRI. Though HSAs won’t solve this problem, at least it will significantly help. HSAs are underutilized, so look into whether you may qualify and see if one is right for you.