What is an HSA Account?

You probably have heard people refer to an HSA account or a Health Savings account before and wondered what it was. Why would someone save money in a health account? Well, today we are going to take a dive into what an HSA account is and who would benefit from using this type of account. 

Let’s get the technical stuff out of the way first! 

What is an HSA account?

A Health Savings Account (known as an HSA from here on out) is a tax-advantaged savings account to be used for medical and other approved expenses, available to US taxpayers who are enrolled in an HSA approved high-deductible account. 

There are some significant tax benefits that can be had, especially if you have an employer-sponsored plan. See the tax benefits section below. 

Some employers will even contribute to the HSA on your behalf as an incentive to use this plan. This is essentially free money to pay medical expenses so make sure you claim it! 

One of the main benefits of an HSA compared to other medical savings accounts is that you are allowed to maintain a balance in the HSA account and do not need to spend the account down to zero each year. This allows you to “save” in the account for future large expenses. I will talk through strategies to use this as a savings vehicle down below. 

These accounts can be normal savings accounts that just offer an interest rate for earnings potential, or some offer investment options where you can invest a portion of the account in stock market holdings to capture some growth. 

Who can contribute to an HSA account?

Any US person, who is not claimed as a dependent on someone else’s tax return, who is covered under an HSA eligible high deductible insurance plan, and is not on medicare.

How much can I contribute to an HSA account?

The contribution changes annually. For 2021, the following contribution limits apply:

Single coverage: $3,600

Joint/Family coverage: $7,200

Catch up if one or both participants are over age 55: $1,000

One key to note is the contribution limit is based on who is covered by the plan. If one spouse age 50 is covered under an HSA and is married to a spouse age 56 who is covered by a different non-HSA eligible plan, then they would be limited to contributing $3,600 into an HSA for 2021 even though they file a married filed joint tax return.  

If this same situation also included a child age 20 who is also covered under the same HSA plan as the first spouse, then they would qualify for the family-level contribution of $7,200, but not the catchup because neither the first spouse or the child is over 55 years of age. 

What can I use the money for?

The money can be used for certain health, dental, and vision costs incurred by anyone covered under the high deductible plan, their spouse, or eligible dependents. 

There are many intricacies to the law and the rules change often. This site has a good list of what is covered, but it is an insurance company site that may not be updated when regulations change. The ultimate authority over these HSA’s is the IRS, so you can find the most up-to-date regulations here (it’s not very user-friendly though!).

What are the tax effects of an HSA account? 

The tax benefits are 3 fold:

1. Contributions you make to the account are tax-deductible (if an employer withholds the contributions from your paycheck, your W-2 will reflect these tax savings in the wages reported in Box 1 of your W-2). Otherwise, you can deduct them in the Subtractions section of the 1040 tax form. 
2. If you are contributing to an HSA through your employer, your payroll deduction contributions are not subject to Social Security and Medicare tax. The wages reported in Box 3 and 5 of your W-2 will reflect this deduction.
3. Any interest or earnings in this account are tax-free as long as they are spent on qualified medical expenses. 

Who can benefit from using an HSA? 

Everyone who is eligible can! These are incredibly flexible accounts, and pretty much anyone who contributes to an account can get a benefit in one or more of the ways I outlined above. Let’s look at some examples:

Lisa is a 25-year-old employee whose employer offers an HSA account. She is healthy, usually goes to the doctor once a year, and urgent care for some sinus thing that seems to pop up each winter. Her employer offers an HSA and will put in $600 a year in the account for her. Lisa can contribute up to $3,000 through her employer for the year. 

She will save approximately 30% of her contribution on payroll (7.65%) and income (assume 22% tax rate) which amounts to $900 each year. Plus she gets $600 of free money (no taxes paid on it!) from her employer totaling a $1,500 benefit each year! 

Jill just got married and now is able to join her husband on his health insurance and is eligible for an HSA account. Both Jill and her husband are healthy and have 2-4 appointments a year. They are thinking of having their first child 3 years from now. 

Jill and her husband can start stashing up to $7,200 per year into the HSA through her husband’s employer, this year and in future years to have money in the account ready to pay for any costs related to their child’s birth.  They will save approximately 30% of their contribution on payroll (7.65%) and income (assume 22% tax rate) which amounts to $2,160 each year. 

If there are medical costs that Jill and her husband have during the year, they can choose to pay for them from the HSA or pay them outside of the HSA using regular spending money. If they start now, they could have approximately $21,000 in the HSA when the baby is born to be used for the delivery cost or any other medical costs in the first few years for the mom and the baby. That is a comforting safety net!

Marie is the busy stay-at-home mom for 4 children. She and her husband are covered under an HSA eligible high deductible plan and her kids are on the state Medicaid plans.  If her husband contributes the max of $7,200 to an HSA account each year through his employer, they will save approximately 20% of their contribution on payroll (7.65%) and income (assume 12% tax rate) which amounts to $1,440 each year. 

The HSA money can be used for both Marie, her husband, and all of the kids! Even though the kids are on non-HSA plans, they are dependents to Marie and her husband, so they are eligible to have the money used for them. With 4 kids, you can bet they use up all of their contribution each year! 

Diane is 55, not married, and recently left her job due to burnout and is going to be starting a freelance business next year. She purchases an HSA qualifying health insurance plan on her State Exchange.  She is able to contribute $4,600 to an HSA account each year and will save approximately 22% of her contribution in income tax, which amounts to $1,012 each year. 

How to use an HSA as a pseudo retirement account

Over the past few years, an idea has been floating around the financial community to use this wonderful HSA account, with its many tax benefits, as a pseudo retirement account. 

People would max out the contributions each year, and then pay for any incidental medical expenses out of pocket without tapping into the account. 

This allowed the HSA account to grow each year, they would invest in some broad-based stock index fund, and would not be required to pay tax on the growth of the account as long as it was used for medical expenses at some point in the future. 

The possibilities are huge for growth. Let’s look at Lisa’s case above. She is young, so the account is maxed at $3,600 every year for the next 30 years (until she is 55). All but a nominal amount is invested in an S&P index fund earning an average rate of 10%. 

In 30 years, the balance in her account is $512,000.

That is half a million dollars! What!

Part of that is the magic of compound interest, which given the time can be incredibly powerful. By doing this, and having so much time to let it grow, Lisa is essentially self-insured for any medical expenses for the rest of her life, potentially even long-term care.  I even assumed that the contribution rate wouldn’t change, but it will probably increase slightly with inflation, so in real life, this could be significantly higher. 

Even if you are later in life than Lisa, these accounts can still be impactful. Let’s say that Diane contributes the max of $4,600 to her HSA for the 10 years until she is age 65 and can enroll in Medicare. At this time she is no longer eligible to contribute to an HSA. But she can keep the account and begin spending the balance on qualified medical expenses. 

After the 10 years of contributions and growth at an assumed 10% interest invested into an S&P tracking index fund, the balance in her HSA is now $80,600. She can’t make any new contributions now, but she also can just let the account grow. If she lets the $80,600 grow for 10 additional years, with no new contributions, she will have $209,000 at age 75. That balance will go a long way to cover significant medical costs or possible long-term care needs. 

Possible downsides

There are a few downsides to this amazing plan of compounding wonderfulness. 

1. The account is tied up for medical expenses unless you want to pay a penalty to access the money. So, you want to make sure you have sufficient cash reserves outside of this account to cover emergencies. You should use cash or taxable brokerage funds first, Roth IRA contributions second, and an HSA should be a low priority to use in a non-medical emergency. If there are any medical or qualifying expenses, then make sure you tap the HSA to get that money out!
2. HSA’s are a relatively new type of account, they were created in 2003. These accounts are governed by tax law set by Congress and can be changed, canceled, or amended at any time. It runs the risk of having a huge account balance in 30 years and having Congress change the law and suddenly you have to withdraw/close the account and pay a penalty for non-medical use of the account. That would be a worst-case scenario, but something to keep in the back of your mind. Make sure you are not putting your eggs in one basket and relying only on your HSA. Your IRA and 401(k) to the match should be a higher priority. 

So, are you ready to lobby your employer for an HSA eligible plan yet? Not many people take advantage of these plans, and many people are not even eligible for them. But if you are, and can take advantage of a few years with low medical expenses, you can have a powerful tool in your hands. 

I currently have an old HSA account that I can’t contribute to anymore. But I keep it as my “hit by a bus” fund. If something catastrophic happens, I get in a car accident, or get cancer, I have a significant amount of money ready to cover my medical expenses without having to worry about how to pay for things insurance doesn’t cover. 

I know I didn’t cover all of the nuances of the HSA. If you have questions about the account or using it, leave them in the comments below and I will share my expertise!

Do you have an HSA? If you do, I would love to hear how you are using it in the comments below or over on our Instagram page.