I’m clueless when it comes to cars. I take the bus to work, MAX to the airport and pretty much avoid driving at all costs (thanks Uber!). And despite my best efforts, my life is still dependent on them. You can imagine my anxiety when it comes to dealing with mechanics. They might as well be speaking a foreign language. As with most of life’s mundane occurrences, I can relate with Seinfeld’s George Costanza and Jerry Seinfeld conversation about mechanics.
As a financial planner, I’m sympathetic to those intimidated or frustrated with the financial services industry. After all, getting a new carburetor is one thing, investing your nest-egg or navigating the tax-code is whole other. For those that feel this way about coordinating their finances, this blog post is for you and is going to focus on one area of financial planning that has gained popularity in recent years: Health Savings Accounts.
What are HSA’s?
An HSA is a tax-sheltered, hybrid savings account available to those with a high-deductible health plan (HDHP). Because these types of health plans come with lower premiums but higher out-of-pocket costs (deductibles & co-pays), individuals are allowed to offset their health care costs by funding HSA’s with pre-tax dollars (e.g. 401k).
All contributions can be invested for future growth in which any earnings are tax-free (e.g. 529 plan).
When it comes time to access the funds for health care costs, any withdrawals used towards qualified medical expenses are tax-free (e.g. Roth IRA).
Essentially, the IRS has created a utopian form of savings vehicle:
How much can you defer?
The maximum deferral amount for 2018 is $3,450 for Individuals and $6,900 for Families. For those older than 55, you can make an additional $1,000 “catch-up” deferral. Similar to deferrals to a 401k, there is no income limit phase out.
What are qualified-medical expenses?
Any standard out-of-pocket health care expenses including:
- Dental treatment
- Doctor's visits
- Eyeglasses, contact lenses and exams
- Fertility enhancements
- Hearing aids and batteries
- Operations/surgery (non-cosmetic)
- Nursing services
- Physical therapy
Can I use HSA to pay for health-care premiums?
Penalty-free HSA withdrawals can only be used for the following health-care premiums:
- Long-Term Care
- Health care continuation coverage (COBRA)
- Medicare (but not MediGap)
What’s the penalty if I use funds for non-qualified expenses?
Prior to age 65, non-qualified withdrawals are treated as taxable income and subject to a 20% tax penalty.
Once you reach age 65, there is no longer a penalty but non-qualified distributions will still be taxed at ordinary income rates (like IRA distributions).
Should I fund my HSA?
It’s pretty easy to understand that HSA’s should be viewed favorably in the eye of the tax-payers. What’s not so straightforward is how to use the HSA in conjunction with other available saving vehicles. Indeed, according to the Employee Benefits Research Institute, roughly 7 million people enrolled in HDHP’s do not fund HSAs. Or in other words, they are forgoing tax-free savings opportunities.
The only financial reason for skipping on the HSA option is cash flow constraints. For those in this category, we recommend the following funding prioritization:
Everyone should be taking advantage of any employer match in the 401(k). Leaving free money on the table is never a good idea.
Step #2 is most likely a deviation from must funding strategies. The primary purpose of the HSA is to promote savings and help mitigate health care costs. Even if cash flow is tight, the HSA can and should act as a conduit account to fund expenses and should be funded ahead of all other vehicles.
For those that can afford to fund savings beyond the 401k match and HSA, the optimal savings vehicle will be dependent on variables like objectives, time frame or fund options.
Compounding Growth & HSA Flexibility
For those that don’t require immediate use of the funds or can afford to pay health-care expenses out of pocket, this is where the real savings opportunities come into play. If you’re in this camp, we recommend treating the HSA as a long-term savings vehicle. Because of the unique tax-treatment and the ability to invest in low-cost mutual funds, there is little downside to funding HSAs annually and investing for the long-term.
For those concerned with over-funding the HSA, the ability to pay for Medicare premiums and the flexibility granted by the IRS practically nullify this concern. As it stands right now, the rules allow individuals to withdraw funds for qualified expenses that were incurred in previous years than the distributions.
For example, assume 2018 is lousy year and requires unusually high health care expenses to the tune of $15k that can be funded out-of-pocket. Now fast forward to 2024, it’s time to purchase your Hawaiian vacation. Instead of paying with funds saved in your taxable account, you have the option to utilize your HSA funds tax-free as long as you can provide receipts for all of 2018’s qualified health-care costs.
Qualified HSA Funding Distribution (QHFD)
A little known quirk in the tax code allows individuals to do a one-time transfer from their IRA to the HSA, up to the annual HSA contribution limit. This is allowed once per lifetime and the transfer is not taxable or subject to the early distribution penalty.
This would be a good option for those looking to jumpstart their HSA funding. However, this should be taken advantage by all retirees because it allows for tax-free distribution of IRA assets.
Still have questions?
At Cordant, we’re committed to helping our clients understand the tradeoffs that come with each financial decision. Admittedly, optimizing an HSA won’t make you filthy rich or save you from the next bear-market but remember, it’s the little things that count. If you’re interested in maximizing your resources or accelerating your path to retirement, get in touch.