Health Savings Accounts - The Total Trifecta
Health Savings Accounts (HSA) made the roster of tax-deferred accounts. For this reason, these accounts can be a favorable component in a financial plan both today and in the future (65+ years old). HSA accounts were first introduced in 2003, and since then, their utilization among employees and employers has grown meaningfully. In order to be eligible to participate in an HSA – an employee must be covered by a High-Deductible Health Plan (HDHP) and not be enrolled in Medicare or other health coverage. Like an employer-sponsored retirement plan, a Health Savings Account offers benefits for both employees and employers. As such, their increased popularity is hardly surprising.
While there are many benefits of HSA accounts, we must also recognize that switching from a PPO plan to an HSA often results in more out-of-pocket medical expenses during the year. Yes, we agree that sounds unappealing. However, there is always more to the story.
Benefits of HSA accounts to Employees
The account is portable. Contributions to HSA need not be used in the tax year they are made. Additionally, if an employee changes jobs, the account is still accessible.
Health Savings Accounts do not impose income limitations. Unlike IRAs, highly compensated individuals are still eligible to participate in these tax-deferred accounts.
Health Savings Accounts provide a trifecta of tax savings:
Employee contributions are federal-tax deductible.
Federal tax on investment earnings is deferred until withdrawal.
All withdrawals (including earnings) used to pay for qualified healthcare costs are free from federal taxes regardless of when they are made.
Dollars contributed to an HSA are both literally and psychologically compartmentalized for medical expenses.
Benefits of HSA accounts to Employers
The time and money employees spend on healthcare is often more efficient with an HSA. This seems intuitive because unlike an FSA, employees have ‘skin in the game’.
Employer contributions to their employees’ HSA accounts are exempt from FICA taxes. In 2020, the combined FICA rate is 7.65% which is not insignificant.
Offering an HSA plan further diversifies the benefit offerings for their employees.
Hierarchy of Retirement Savings
For those with an employer-sponsored retirement plan and an HSA account, there is a hierarchy for where to best save one’s dollars. This hierarchy assumes the employee does not have significant debt and has also created an emergency savings fund.
First Priority: Take full advantage of the 401k employer match. Free money!
Second Priority: Maximize your HSA contributes and invest your dollars for the future.
Final Priority: If you have extra earnings, contribute the maximum to a 401k plan or a Roth IRA.
Here is an example scenario of the three-step hierarchy above:
Sophia’s employer matches 50% up to 6%. Melissa should contribute 6% to her 401k plan, and her employer will contribute 3%. Free money – check.
Next, Sophia should maximize her annual HSA contribution. Trifecta of tax savings – check!
Finally, Sophia can contribute additional funds to her 401k plan to maximize her annual contribution and/or contribute to a Roth IRA.
Withdrawal Rules
There are early withdrawal restrictions for Health Savings Accounts to ensure individuals are using their account for the intended purpose: paying for medical expenses. Specifically, HSA’s incur a 20% penalty and income tax on any amount withdrawn before age 65 that is not used for medical expenses. That said, an HSA account should be opened with the pure objective of saving and paying for inevitable health expenses throughout one’s life.
When you have your inevitable health care expenses, you can also pay out-of-pocket and keep the receipts for tracking your deductible. From a long-term growth and tax perspective, this may be advantageous if you have extra savings in your bank account.
Investment Strategy
Most HSA accounts have a minimum cash balance required. Once you have saved the minimum cash balance, the additional dollars can be invested. The investment strategy within your HSA account will vary depending on your financial landscape, but often the investment strategy is aligned with your other retirement accounts – like a 401k or an IRA.
Prioritize your health
It is absolutely imperative to acknowledge that HSA dollars should be spent on health and wellbeing as needed. As exciting and opportunistic it is to imagine a future tax-deferred balance, health today must be prioritized. We do not work in the health sector, but at Human Investing we have a team of financial advisors who are committed to ensuring your medical costs are accounted for in a strategic manner.