Health Savings Accounts (or HSAs) are sometimes referred to as “triple tax free”. Contributions to the account are made pre-tax. Income inside the account is tax-free. Finally, distributions from the account used are made tax free when used to pay for qualifying medical expenses. This combination can make them very attractive.
From my conversations over the years, most people use their HSA to pay for current medical expenses. The account is kept in cash and contributions are distributed the year they are made. Some people may benefit from a different approach and use their HSA to save for potentially larger health care expenses in the future such as long-term care needs. For those able to pay more out of pocket today, they may be able to accumulate an investment account that qualifies for tax-free distributions, potentially replacing the need for expensive long term care insurance.
Background
Company health insurance plans fall broadly into two categories, traditional or high deductible. Both have a premium, which may be shared by an employer or paid entirely by the insured. Traditional plans typically have a lower deductible. When you get medical care, you pay a copay that represents a portion of the total cost. You may have a deductible as well, which is a share of the cost that you will need to pay.
This Health Savings Account (HSA) accumulation strategy applies to high deductible plans. High deductible plans typically do not share in covering any medical expenses until after you have paid a specified amount out of pocket (the high deductible). This can frequently be several thousand dollars. To make this more affordable, many high deductible health plans are paired with a Health Savings Account (HSA). With an HSA, you can make pre-tax contributions of up to $3,850 per person or $7,750 per family for 2023. For 2024 these figures will increase to $4,150 for individuals and $8,300 for families. Distributions from the HSA account are tax free if used for eligible healthcare expenses.
Using your Health Savings Account for future Long Term Care expenses.
HSAs permit you to make a tax-free distribution to pay for medical expenses. While I have never seen data on this, I suspect most people make the distributions the same year they make the contribution. This makes sense because you pay for the medical bill using pre-tax dollars.
For those who have the means to pay medical expenses out of pocket and are willing to forgo the immediate tax-benefit on those expenses, another strategy is to accumulate and grow the tax-free HSA for later use. The money in the HSA is invested in a portfolio for long-term growth. (Note that if the HSA is used for current expenses, I generally suggest that it be kept in cash.)
The potential benefit of this strategy can be substantial. Let’s look at an example.
Example
Jennifer, age 30, is starting a new job with an employer that offers a high deductible health plan paired with a Health Savings Account. Jennifer is healthy and doesn’t visit the doctor often except for an annual physical. She reasons that she can afford the out-of-pocket expenses and can accumulate her annual contributions of $3,850 in the HSA. She plans to not touch the money until she retires at age 66, and she thinks he can achieve a 7% investment return.
If Jennifer’s assumptions are correct, over the next 36 years she will save $138,600 pre-tax. Her 7% annual growth would make the account grow to $598,512 tax-free.
The HSA contribution limit is tied to inflation, so she may be able to increase contributions in future years. Also, if Jennifer gets married and has a family, their combined contribution increases to $7,750, allowing them to save even more.
Accumulating this account will give Jennifer options as she gets older and starts to consider how she will pay for potential long term care expenses. Knowing that she has a tax-free source of funds for health care may permit her to pay for expensive long-term care without insurance or other medical care.
Jennifer can take tax-free distributions for current health expenses whenever she needs them. If she is diligent about keeping records of her qualified medical expenses paid out of pocket, she may be able to make tax-free distributions for those expenses even years in the future. In the meantime, the account can remain invested and hopefully growing.
Potential Benefits
The potential benefits of having an HSA to fund future health expenses can be significant. Here are a few examples.
- Out of pocket medical expenses such as co-pays or procedures not covered by insurance. For many wealthy individuals, this may be the greatest benefit because you may be able to access care or services not generally covered by insurance. Generally, any expense the IRS would qualify as a deductible medical expense qualifies, but they also include some other expenses such as over the counter medications. It’s best to consult the IRS list to see which expenses qualify.
- Long term care expenses including policy premiums. The amount of the premium you can pay from your HSA is based on a formula and increases with age.
- Bridging your health insurance premiums if you retire before Medicare eligibility begins at age 65. Private health insurance premiums aren’t eligible HSA expenses, but there are two exemptions. Premiums for COBRA coverage after separating from a job, or paying for private insurance while you are collecting unemployment benefits are generally eligible expenses.
Considerations
This strategy works best the earlier you start it to allow more time for contributions to accumulate and potential compounded growth. It is most effective in HSA plans that allow you to invest the account balance in long-term investments such as stocks and bonds rather than only cash.
Beware of the penalty for distributions not associated with medical expenses. In addition to taxing the value of the distribution as income, they are subjected to an additional 20% tax.
The account is available now or in the future. If you have an immediate expense, you can tap your HSA. Remember that it’s possible this could happen in a bad market, so be certain you have other funds available if you invest the HSA aggressively. You could also keep a portion of the HSA in cash to cover short-term needs.
Remember that an HSA is not a substitute for insurance. The money you have available to you is limited to the value of the account. While the hope is to grow the account for the future, in the near term you will not have as much available. In some instances, insurance coverage that could pay a larger benefit if needed may be desirable.
Keep good records of the medical expenses you pay. While you can take money out for current year expenses, having records of past expenses will allow you to make tax-free distributions in the future, even years later. Many health insurance companies will let you save a summary of expenses for the past year or more. I like to do this annually when organizing my income tax data.
HSA accounts can be inherited by a spouse. However, they’re not tax efficient for other beneficiaries such as children. In this case, the entire HSA becomes taxable to the child in the year of death and there are no stretch provisions such as there are with an IRA. Because of this, it’s often best to plan to deplete them for health expenses during your lifetime. Some people may choose to leave their HSA as a qualified charity to avoid this taxation.