Are HSAs good? What should I do with mine?
Updated: Aug 31, 2022
First off, let me say, this isn't advice tailored to your individual situation. HSAs aren't a good fit for everybody, as I discuss at the end of this article. But if it's a good fit, HSAs can be pretty phenomenal. Why? For starters, HSAs are triple-tax advantaged. That means:
The funds you contribute to them are tax deductible, and unlike 401(k) contributions, can even reduce your payroll taxes (FICA and Medicare).
The funds can be invested and grow tax-deferred.
When you withdraw that money to reimburse yourself for medical expenses, that money is tax free.
Why is that so good? Well, think about how it works when you contribute money to a pre-tax 401(k). You get a deduction that reduces your income taxes, the money grows tax deferred, BUT when you take the money out, you have to pay ordinary income taxes on it. An HSA is the same for those first two steps, but when you take the money out, it's tax-free (as long as you use it for healthcare expenses).
But here's the thing. Those healthcare expenses don't have to have occurred in the same year that you're reimbursing yourself for them. You can reimburse yourself years (even decades) after incurring the expense, as long as you can match that withdrawal to an HSA-eligible medical expense.
As an example, let's suppose you have $5000 in cash, and $5000 in an HSA. You break your leg and incur medical expenses of $5000. Rather than pay from your HSA, make that payment with cash instead, and let the money in your HSA continue to grow. Suppose after 20 years it has grown from $5000 into $20,000 (a 7.2% growth rate). At that point, you can take out $5000 to reimburse yourself from the expense 20 years prior, and that withdrawal will tax-free. This leaves you with another $15,000 that you can use for future medical expenses, or any other unreimbursed expenses from your past. Best of all, that $15,000 can continue to grow tax deferred.
Here's the winning strategy, summarized:
Max out your HSA contributions each year to minimize your tax bill.
Pay medical expenses with after-tax money (such as the cash in your checking account).
Wait while the money grows.
Reimburse yourself with tax-free money.
A lot of people don't do this. In fact, many of them treat it like any other bank account. When an expense comes up, they drain the HSA, and leave the $5000 sitting there in their checking. What a waste! These people could be so much richer, without much effort, but they're not! Don't be like them.
All that said, here are a few key points that could potentially trip you up in executing this strategy.
You have to be able to pay medical expenses out of your cash on hand. This means having a good-sized emergency fund, larger than you might otherwise carry, as well as sufficient cash flows to replenish it.
You need to keep receipts for a very long time. This means scanning and storing a record of all your expenses, and then making sure you don't lose those files and records. This might not be easy to do over timeframes of 20 or 30 years.
If you use up all your receipts, but still want to use the cash in retirement (after 65), you'll have to pay ordinary income tax on withdrawals just like you would with a Traditional IRA or pre-tax 401(k). Of course, you can always leave the money there to cover medical expenses as you age, including long-term care.
Putting yourself in position to use this strategy requires a much higher savings rate. You have to save enough to make HSA contributions as well as build up enough of a cash reserve to cover incidental expenses. This might be difficult to do, particularly early in your adult life.
To be eligible for an HSA, your health insurance needs to be a High-Deductible Health Plan (HDHP), where you're on the hook the first several thousand dollars of medical expenses each year before the insurance starts covering anything. This potentially makes it a bad fit for households with high medical expenses, such as families with young children or people with chronic illnesses.
Similar to the point above, I'd also caution against an HDHP for anyone who should otherwise get necessary and preventative care, but who would stay away from the doctor's office to save money. If something is wrong, see a doctor. Your health (and your life) is worth more than your money. As the saying goes, "he who has his health has many dreams. Without his health, just one."
Don't put your finances ahead of your health, but if you're already using an HSA and it's going well, it might be good to look into that strategy. It's something I help clients with every year.
Obviously, none of this is personalized financial advice. For now, you and I are just two strangers on the internet, without a clue about each other's lives and circumstances. What's good advice for one person might be terrible for someone else. But if you want some personalized advice, please feel free to reach out and I'll be happy to help you figure out what would be best for you.