The Health Savings Account: Even Better than a Roth IRA

In Use it Or Lose It, we talked about the fantastic benefits of the Roth IRA.  While you don’t get any tax break up front, the account grows tax-free, which means that you never have to pay any more taxes on the money, even when you make withdrawals in retirement.  The money is 100% yours!

It turns out that there’s a retirement account that’s even better than a Roth IRA.  It’s called the Health Savings Account (HSA).

The Health Savings Account (HSA)

Like a Roth IRA, a Health Savings Account grows tax free and withdrawals are not taxed as long as you use the money for eligible health-related expenses. The money is 100% yours.  Also like a Roth IRA, it’s  portable and not linked to a particular employer.

What makes it better than a Roth IRA is that contributions can be made PRE-TAX.  This is why the HSA is often referred to as a triple tax-advantaged retirement account.

1. Contributions: Pre-Tax
2. Growth: Tax-Free
3. Distributions: Tax-Free (if used for eligible health care expenses)

If you want to review the main types of retirement accounts, check out this table:

Are you Eligible to Contribute to an HSA?

The HSA is another great gift from the government and I wish everyone was eligible.  Unfortunately, there are eligibility requirements.  You can only contribute to an HSA if  you are covered by a High Deductible Health Plan (HDHP).

For 2017, the definition of a HDHP per the IRS is as follows:

In other words, you can only contribute to an HSA if you have a health insurance plan with an annual deductible of at least $1,300 ($2,600 if you have a family plan).  If your deductible is less than this, or you are covered by an alternative form of insurance, such as a health care sharing program, then you are not eligible to contribute to an HSA.

You are also not eligible to contribute to an HSA if you are taking advantage of a FSA (flexible spending account) or HRA (Health Reimbursement Account), or you are enrolled in Medicare. There are lots of other rules that we won’t get into here, but if you want to punish yourself, spend a few hours with IRS publication 969.

How to Use a Health Savings Account

The Health Savings Account is designed to help you pay for eligible medical expenses with pre-tax dollars.

After you make a contribution to your HSA, you can use the funds for eligible healthcare expenses at any time, including the year in which you make the contribution. However, if you use the money in the account soon after you make a contribution, you lose out on any significant tax-free growth.

The power in the HSA comes from using it as an investment vehicle.  Here’s how it works:

1. Contribute as much as possible to your HSA every year (up to the maximum of $3,400 for an individual HDHP or $6,750 for a familyHDHP).
2. Pay any medical expenses that come up with cash funds OUTSIDE of your HSA and SAVE THE RECEIPTS.
3. Leave the funds in your HSA.  They will roll over from one year to the next.
4. Invest the funds in your HSA in a mutual fund or other investment.
5. Enjoy the tax-free growth over decades.
6. When it comes time to withdraw funds from your HSA in retirement, you can withdraw it tax-free as long as you have receipts showing health-related expenses totaling at least as much as the amount you have withdrawn.

Everyone has health-related expenses, so you shouldn’t have any problem finding enough healthcare-related expenditures to back up your withdrawals.  In the unlikely event that you don’t have any health-related expenditures, then you will have to pay taxes on the principal and earnings in the account (like a 401k) and will also owe a 20% penalty.

What Qualifies as a Health-Related Expenditure?

Based upon IRS publication 502, check out what qualifies and does NOT qualify for payment with funds from an HSA. Sorry, marijuana doesn’t count.

How to Contribute to an HSA

If your employer offers a specific HSA insurance plan, then you may be able to contribute pre-tax dollars from your paycheck.

If your employer does not offer a specific HSA but you are covered by a high deductible health plan (either through your employer or on the ACA exchange), then you will need to find an HSA provider to open up an account independently.

I wish this part was as easy as a Roth IRA.  Unfortunately, it is not.  Vanguard does not offer an HSA (hopefully in the future)!  Fidelity offers an HSA, but only for companies, not individuals.  This leads us to the drawbacks to an HSA (there’s a catch with everything).

Drawbacks of an HSA

Health Savings Accounts are excellent investment vehicles and if you have a high deductible health plan you should definitely use one.  However, you should also be aware of the drawbacks.  Compared to a Roth IRA, HSAs have:

1. Higher administrative fees
2. Lower yearly contribution limits
3. More limited investment options
4. More hassle in opening up an account

Choosing an HSA Provider

Despite the drawbacks, put your head down and learn how to choose an HSA provider.  There are several important factors to consider:

1. Fees:  Unlike a simple Roth IRA, fees abound in the world of HSAs.  These fees include account opening and closing fees, maintenance fees, and investing fees.
2. Investment options: Some HSAs only allow investment in a savings account or CD (certificate of deposit), rather than mutual funds.  Others allow investments in mutual funds, but the funds have high fees or are otherwise undesirable.
3. Minimum amount to start investing:  This ranges from $0 to $5000.  Obviously lower is better in the first year you start contributing to an HSA.
4. Assets under management: Other things being equal, you would want to choose an HSA provider with greater assets under management because this indicates that they are well established.

I’ve assembled a comparison chart (below) to help with your decision making.  The chart focuses on the larger and more established providers.  I’ve only included providers  that allow investments in mutual funds, not just CDs.  After all, you want to use your HSA as an investment vehicle!

The information from this table comes from a variety of sources including HSASearch.com, Investor’s Business Daily,  and 20SomethingFinance. 

This is just a small sampling of the HSA providers available.  You can use HSAsearch.com to research other providers.  I would also encourage use to go directly to the provider’s website to confirm the fees, investment options and other details before you sign up.

If you’re feeling overwhelmed by all the options, here’s what I recommend:

1. If you’re just starting out, choose a provider with a low investment threshold and relatively low fees.  This year is the first year that my wife and I qualified for a HSA and we decided upon Select Account.  There is a relatively low $12/year maintenance fee, an $18/year investment fee and no fee if we decide to close the account and switch providers.  $1,000 stays in the HSA savings account and $2,400 is in the investment portion, invested in a very low cost Vanguard 500 index fund.  I have also been impressed with Select Account’s customer service.
2. As your HSA grows larger (to say $10,000), then you may consider moving it to HSA Bank and use their self-directed brokerage option.  You’ll keep $5000 in the savings account portion, avoid all the fees and have access to whatever funds you want.  If you contribute to your HSA once per year at the beginning of the year, and you’re only purchasing three funds, you’ll pay around $20/year ($6.95 x 3 trades) in order to invest.

As you can see, selecting and contributing to an HSA is much more complicated than just selecting Vanguard for your Roth IRA.  However, don’t get too bogged down in the details.  You’ll probably be fine regardless of which provider you choose.

Take note that if you’re contributing to an HSA on your own (i.e. not through your employer), you’ll contribute initially with after-tax dollars, but when you file your taxes, your taxable income will be reduced by the amount you contributed to your HSA (up to the contribution limits, of course).

Summary on HSAs

Health Savings Accounts are triple tax-advantaged investment vehicles.  If you have a high deductible health plan, you should max out your HSA.  Pay for medical expenses with funds OUTSIDE the HSA, save the receipts, and leave the funds alone to grow tax free in a reasonable mutual fund.  In retirement, you’ll have a large stash of tax-free money that the government can’t get their hands on.  Pop the cork and celebrate.

Revisiting the Big Picture

Don’t get lost in the details. This post was especially full of them. Work on saving 50% of your income.  Most people will do this primarily through tax-advantaged investment accounts.  Here’s the general order in which you should be contributing to your retirement accounts:

1. Contribute to your 401k up to the employer match (usually around 4% of your paycheck, but this obviously varies)
2. Max out your Roth IRA ($5,500 per year for you and $5,500 for your spouse)
3. Max out your HSA (if you qualify) ($3,400 per year for an individual HDHP or $6750 if your HDHP covers the entire family)
4. Max out the rest of your 401k ($18,000 per year)
5. If you’re still not up to your 50%, put the rest in a taxable account

If you can max out your 401k, Roth IRA, and HSA every year, you’ll be well on your way to earning your freedom.  Good luck and happy saving!

Remember, It’s Not About the Money; It’s About the Freedom