Sometimes the little things add up in life. They are not so little when you compound them over decades.
I see so many people trying to eke out another 0.1% from their money market fund or looking for ways to reduce their taxable income. Meanwhile, sometimes this one thing is mostly ignored or not taken full advantage of. That thing is a Health Savings Account (HSA).
In order to have an HSA, you must be enrolled in a high-deductible health insurance plan. For 2019, the limit for contributions is $3,500 for individuals and $7,000 for families. There is also a catch-up contribution up to $1,000 if you are age 55 or older.
The money you contribute to an HSA is pre-tax money. You will not pay federal income taxes on these contributions.
You may or may not choose to invest the money in your HSA, depending on your plan and your risk tolerance.
You do not pay taxes on this money when you spend it, as long as you are spending it on a qualified medical expense. Unfortunately, you can no longer use it to buy over-the-counter medicine. Obamacare destroyed that one.
This is quite astounding if you think about it. You don’t pay federal income taxes on the earnings that are contributed to the HSA. And if you use it to pay for medical expenses that qualify, then you won’t pay any income tax on the withdrawal. It is almost as if you get the benefits of both an IRA (or 401k) and a Roth IRA.
If you withdraw the money before age 65, or you just spend it on something that doesn’t qualify as a medical expense, then you will owe taxes and penalty. The penalty is rather steep at 20%, so this probably isn’t something you want to do unless absolutely necessary.
Still, since some employers will make a matching contribution, you could still be conceivably better off taking the match and withdrawing all of the money and paying the taxes and penalty rather than not having an HSA at all.
For people close to retirement, this vehicle is particularly beneficial. Once you are over age 65, you won’t owe any penalty. If you use the money to buy a new car (not a medical expense), then you will owe taxes on it. But this is really the same as if you took money out of your 401k plan. So, once you are 65, an HSA is at least as good as a 401k. And if you need it for medical expenses, then you won’t pay any income taxes on it. (Check your state tax laws to make sure this also applies to your state.)
There is a long list of things that qualify as medical expenses for your HSA. You can find the list for 2018 here. When you consider that it includes eye exams, eyeglasses for medical reasons, dental expenses, and a whole host of other things, you probably won’t have much trouble spending the money.
The Downsides
As with almost everything, there are downsides. This is a government creation, which means it is subject to change. Obamacare already eliminated a lot of items that previously qualified, and there is nothing to stop another change except perhaps voter outrage.
The government could even technically change other rules for the accounts. The politicians could decide to impose a tax on some of the money, even if it is used for medical expenses. They could change the age (or eliminate the age) for withdrawal without a penalty.
This is the same reason I caution people about a 401k plan. It is probably not a good idea to stake your whole retirement on the idea that the government is not going to change the rules.
When it comes to an HSA, I don’t think there will be radical changes, but there could be some changes as was seen with Obamacare. They mostly got away with that without a riot from the populace. If they completely changed the tax-free status of money already contributed to HSAs, then you might actually have a riot on your hands.
Please note, I am not a CPA, and I am not an expert in this subject. Please do your own research to verify my claims above. Also, beware that the contribution limits typically change each calendar year.