Most people know that Roth individual retirement accounts (IRAs) have a “5-year rule,” that is,…
The Most Underused Benefit in the IRS Tax Code
The IRS Tax code is not typically known for offering a free lunch. However, there is one type of account out there that many people have heard of but don’t fully understand how beneficial it can be.
The Health Savings Account, or HSA.
Let’s start by discussing what an HSA is not: a Flexible Spending Account, or FSA. A FSA works as a use-it-or-lose-it type of account, although many companies now allow you to roll a nominal amount to the next year.
The HSA crushes the FSA because it can act as an ACCUMULATION account that offers better tax treatment than an IRA or Roth IRA, because it combines the best of both. The HSA offers a triple tax benefit.
- Contributions are tax deductible, and avoid FICA taxes if made through your payroll system. This is similar to the benefit of a Traditional IRA.
- Once the account reaches a certain threshold, usually $1,000-$2,500, the funds can be invested and the earnings grow tax deferred. In both the Traditional IRA and Roth IRA you are not taxed on investment growth in the year it happens. With the traditional IRA the tax is deferred until you the funds are withdrawn, with the Roth the investment growth is never taxed.
- Lastly, you can spend the funds tax free as long as they are spent on qualifying medical expenses. The Roth IRA also allows for tax free withdrawals. Qualifying expenses include: doctors’ visits, co-pays, dental treatment, prescriptions, eyeglasses and contacts, Medicare premiums, and more.
The previous paragraph explains why the account is so underused. Only a small minority of HSA owners use the account for accumulation, instead treating it much like a FSA on current expenses. I strongly encourage our readers to consider using the account to use the HSA as an investment account if they can afford to pay for current medical expenses with other funds.
A common objection to this strategy goes like this: what if I don’t have enough medical expenses?
That would be extremely unlikely considering Medicare premiums are qualifying expenses and the likelihood of increased healthcare spending as you age. Also, you can save current medical receipts and request reimbursement years later! The only requirement is for the HSA to have been open at the time the expense was paid. This strategy just turned the HSA account into a supplemental retirement account with tax free dollars or allows you to treat the account like an emergency fund. Need a couple grand for a new furnace? Simply submit old receipts for reimbursement and you receive those funds tax free.
Limitations Regarding HSAs
There are some important limitations regarding a HSA. While HSAs are becoming much more common we still see some employers that don’t offer them yet. You are only allowed to contribute to the HSA if you have a High Deductible Health Plan (HDHP). HDHP’s typically offer lower premiums, but potentially higher total out-of-pocket costs if a lot of medical care is needed. These can often save your household on overall medical expenses, especially if your family is healthy. If funds are used for non-qualifying expenses, you would pay tax on that amount plus a 10% penalty if you’re under the age of 59 ½. 2017 contributions are limited to $6,750 for a family, $3,350 if you’re single (add $1,000 to each if you’re 55 or over), but no limit on growth.
Inheriting an HSA
It is also important to note the way HSAs are treated as inheritances. Spouses can treat the inherited HSA as their own, but non-spouse beneficiaries must include the HSA balance as taxable income. However, this amount is reduced by a qualified expenses paid by the beneficiary within one year after the date of death. For this reason, HSA funds should generally be used before taking Roth IRA distributions and it could make sense to make the contingent beneficiary low-income individuals, charities, or your estate.
Has your advisor talked about the HSA?
The type of advisor you work with becomes very important with a strategy like this. Sales agents for investment and insurance companies would much rather see those funds go toward insurance premiums or managed investment accounts. A fee-only advisor acting as a full time fiduciary doesn’t have that same bias and can objectively review the pros and cons with you. It’s also important to note that the Trump Administration has proposed drastically increasing the contribution limits. If that happens, the strategy we’ve discussed becomes that much more powerful and illustrates why working with an advisor on an ongoing basis can be so valuable.