Health Insurance

How To Use An HSA As a Financial Tool

HSAs let you claim qualified medical expenses to defray out-of-pocket costs, but also offer the potential for tax-free investment and retirement savings growth. Here’s what you need to know about how HSAs work and how they stack up against other retirement savings options. 

How To Use An HSA As a Financial Tool

A health savings account (HSA) offers a way for individuals on high-deductible health plans (HDHPs) to save money for eligible medical expenses and reduce the amount they pay out of pocket. But these plans also come with another potential advantage: You may be able to use it as an investment tool for retirement.

See how HSA benefits stack up against other retirement-funding options, such as FSAs, 401(k)s, and IRAs.

Why Use Your HSA for Retirement?

Because funds placed into an HSA can be invested in the same manner as more familiar retirement savings vehicles such as 401(k)s and IRAs, it is possible for investors to grow their savings steadily over time. Contributions to an HSA account are tax-deductible, and funds in the account grow tax-free, in turn making it possible to drive significant savings growth over time with minimal loss. 

There are four requirements for opening an HSA:

  • Applicants must be covered under a High Deductible Health Plan (HDHP), which includes a higher annual maximum than typical health plans, as well as a maximum limit on the annual out-of-pocket and deductible expenses paid by plan holders.
  • Applicants must have no other health care except for that related to liabilities under workers’ compensation or use of property, coverage related to a specific illness, or a fixed period of hospitalization.
  • Applicants must not be enrolled in Medicare.
  • Applicants must not be claimed as a dependent on a federal tax return.

If these conditions are met, individuals may open an HSA to help cover the costs of qualified medical expenses. In 2022, HSA contribution limits are set at $3,650 for individuals with self-only coverage under an HDHP and $7300 for those with family coverage under an HDHP.

How to Use Your HSA for Medical Expenses

The stated purpose of an HSA is to help cover the cost of qualified medical expenses. These expenses include medical and dental procedures, prescription drugs, and copayments. However, insurance premiums do not count as qualified expenses.

If an expense is qualified, individuals contact their HSA trustee to request a distribution. These distributions are tax-free when used for a qualified expense, but if it is used for another reason, it may be subject to both income tax and an additional tax of up to 20%. There is no requirement to access any of your HSA funds during the year, and while there are yearly maximums on contributions, the amount you invest rolls over to the following year while the contribution amount resets.

How to Use Your HSA for Retirement Savings 

Money in your HSA can be invested into the same type of investment accounts used for 401(k) and IRA retirement planning. You can choose high, medium, or low-risk investments that meet your needs and allow that money to grow over time tax free. 

Advantages of Using Your HSA for Investing

There are several HSA benefits for investing, such as:

The triple tax benefit

Contributions to your HSA account are tax deductible, funds in your account grow tax free, and withdrawals for qualified medical expenses are tax exempt. This means that you do not pay tax on the money you put in, interest you earn, or disbursements you take, so long as these withdrawals are for qualified medical expenses. In effect, this allows you to use your HSA as a tax-free, medical expense retirement savings account. 

No minimum withdrawal age

You can keep funds in your HSA until you are ready to use them. Unlike IRA and 401(k) accounts, there is no minimum withdrawal age for HSAs. While both IRAs and 401(k)s require you to start withdrawing a portion of your savings at age 72 — and pay an associated tax — you can wait to use your HSA until you are ready or leave it alone and have the balance transfer to a beneficiary when you die.

Can be employee and employer-funded

You can self-fund your HSA investment, or you can ask your employer to contribute to it in the same way as a 401(k) or IRA if this is an option. You can also do a combination of both to help reach the maximum contribution amount each year. Other options, such as an FSA, are entirely employer-driven, giving your HSA more flexibility in this area.

Disadvantages of Using Your HSA for Investing

There are also some potential downsides of using your HSA for investing, including:

Tax still applies for non-medical expenses

If you withdraw money from your HSA for non-medical expenses or non-qualified medical expenses, you pay income tax on the amount withdrawn. You may also be subject to a 20% tax penalty, which means that if you withdraw $1,000 for a non-qualified expense, you could end up paying $200 in penalties plus income tax. 

HSA plans require an HDHP

To open an HSA, you must be enrolled in an HDHP. This makes them less flexible than other types of investment accounts which you can choose to open at any time. HDHPs also come with higher deductibles and out-of-pocket costs than other health care plans, meaning it is worth doing the math to see if what you can invest in your HSA outpaces the potential cost of your health care.

Substantial reporting requirements

Detailed tracking of expenses and contributions is required to maintain your HSA’s tax-free status. This means filing forms such as IRS form 8889 every year, which details your contributions to your HSA, those of your employer, and any distributions taken during the tax year.

HSAs vs. FSAs

Flexible spending accounts (FSAs) differ from HSAs in that they are created and maintained by your employer. While there is no requirement to have an HDHP to have an FSA, the contribution limits are lower — $2,850 for 2022 — and money in the account does not automatically roll over at the end of the year. Employers can decide if FSA funds for qualified medical expenses expire at the end of the year, if employees get a grace period to use these funds, or if they are allowed to bring up to $500 into the new year. In addition, since FSAs are owned by employers, they do not go with you when you change jobs unless you are covered for continuation under COBRA.

In practice, there is little difference in using an HSA or FSA for qualified medical expenses. In both cases, you contact your trustee and ask for the funds to be disbursed, then use them to pay off the designated medical expense. While FSAs have a lower overall limit, they still help to reduce the total cost of medical expenses throughout the year. 

One area where FSAs have an advantage over HSAs is in their usability. Unlike an HSA, no HDHP is required. Any employee can access their employer-managed FSA regardless of their health plan type.

When it comes to investing, however, FSAs are not an effective alternative to HSAs because the maximum carry forward amount is $500 and is at the employer’s discretion. This means that the employer can choose not to offer carryover or can choose to eliminate this option at any time. Meanwhile, HSAs are owned by the individual and the full amount saved — including any interest-based growth — carries over to the next year. 

HSAs vs. 401(k)s

401(k) plans — named after a section of the United States Internal Revenue code — are a type of employer-sponsored plan designed to help employees save for retirement. Unlike HSAs, there is no requirement for 401(k) enrollment; if your employer offers this plan, you can choose to participate.

If employees participate in a 401(k) plan, they sign an agreement that allows a portion of each paycheck to be deducted and placed into the 401(k) account. Employers may choose to match some or all of this contribution, and employees are typically given a choice of different fund options for their 401(k) investment to align with their tolerance for risk.

There are two broad types of 401(k)s: Traditional and Roth. In a traditional 401(k), contributions are deducted from gross income, which means they are taken before tax is deducted. These contributions then reduce your total amount of taxable income for the year and can be reported as a tax deduction. Tax on contributions and investment earnings is not due until you begin withdrawing the money. 

In many respects, HSAa and 401(k)s are similar. Contributions made are invested and carry over year-to-year, earning interest and growing total retirement savings. However, where they differ is in how contributions and withdrawals are handled. In an HSA, you can choose to contribute as much or as little as you like over the course of the year. If you are short on money one year, you can contribute more the next, up to the contribution limit. When it comes to 401(k)s, meanwhile, your contribution is deducted directly from each paycheck. 

401(k)s also come with minimum required distributions (RMDs). After age 72, 401(k) account holders who have retired must withdraw a minimum percentage from their accounts based on IRS life expectancy tables. HSAs have no RMDs, so money may be kept or used regardless of your age.

HSAs vs. IRAs

Individual retirement accounts (IRAs) are similar to 401(k)s, except IRAs are not offered by your employer. Instead, you open an account with the financial institution of your choice and contribute money each month, which is then invested and grows over time. In 2022, you can contribute up to $6,000 per year to your IRA, or $7,000 if you are over 50.

There are two types of IRAs — Traditional and Roth — which function the same way as their 401(k) counterparts. Contributions to traditional IRAs are made before tax is deducted, while contributions to Roth IRAs are made after tax is deducted. RMDs also apply: After age 72, you must begin making minimum withdrawals.

In practice, this means that while IRAs offer a higher contribution limit each year than HSAs, there is a limited amount of time in which you can grow your savings before you are required to begin withdrawing IRA funds.

Tips for Getting the Most of Your HSA

If you’re looking to get the most from your HSA retirement investments, start with these 4 tips:

Contribute as much as you can each year

The more you contribute each year, the faster your savings grow. Aim to contribute the maximum each year, or as close to this number as possible. This is because unlike an FSA, there is no limit on how much of your savings can roll over each year, so money put in continues generating interest until you choose to request a disbursement. 

Spend as little as possible

The less you spend out of your HSA each year, the more chance it has to gain interest and grow over time. When possible, pay out of pocket, not out of your HSA. In practice, this means that even if you have a qualified expense that you could use your HSA for, paying out of pocket when you can afford it may offer an advantage since it keeps your savings intact. 

Keep your receipts

While you cannot use your HSA for qualified medical expenses that occurred before you created the account, you can keep receipts for expenses you paid out of pocket after the account was created and then claim them years or decades later. This can help you boost contributions upfront and then reimburse yourself for previous expenses. 

Plan your HSA investment strategy

Once you reach 65 and enroll in Medicare, you can no longer make HSA contributions. As a result, it is worth planning your investment strategy to invest the maximum amount before this happens.

HSA Limitations to Keep in Mind

There are several limitations to keep in mind around HSAs for retirement. First is the end to contributions once you reach 65 and enroll in Medicare. Once this occurs, the balance in your HSA remains, but you are no longer able to make additional contributions.

Next is the need to choose a beneficiary. When you open your HSA, you designate a beneficiary, but depending on who you choose, the amount of money they may receive upon your death may vary. For example, if you choose your spouse, they can inherit your balance tax free. However, if you choose a different beneficiary, they are subject to tax on the plan’s fair market value. 

Finally, it is worth remembering that while federal laws do not tax contributions, some states — such as California and New Jersey — have made HSA capital gains taxable.