An HSA Can Work Three Ways

December 07, 2020

Health Savings Accounts (HSAs) can be a great way not only to protect your family from medical bills, but also to save for retirement and more. HSAs are offered to employees who have high deductible heath plans through their employer. An HSA is the only vehicle that is potentially triply tax-exempt – the contribution is tax-deductible, the account grows tax-deferred, and distributions are tax-free for qualified expenses – all while being invested in the market. Now an HSA can be used to pay for over-the-counter medications, even without a prescription. Please reach out to your team at Financial Plans & Strategies to learn more.

Please see below an article on this topic from Vanguard:


October 29, 2020 | Vanguard Perspective

The cost of health care can pose a significant expense—and a big concern—for your clients.

Whether they're covered by a workplace health insurance plan or a public program such as Medicare or options under the Affordable Care Act (ACA), there’s a good chance that health care costs are top of mind for them right now. Premiums they must pay seem to be ever-escalating; the coronavirus pandemic has heightened health concerns. Such concern can be particularly acute for individuals who do not yet meet the age 65 minimum for Medicare eligibility.

Health Savings Accounts (HSAs) provide a hedge against some of that uncertainty by providing a tax-sheltered, tax-deductible savings and investment vehicle. While the main purpose of HSAs is to defray health care costs, their flexibility also makes them a versatile and powerful tool for building wealth.

You and your clients can learn more about HSAs; how to use them optimally; and important, recently enacted changes from a research paper in Vanguard's Financial Planning Perspectives series—HSAs: An-off-label prescription for retirement planning.

The HSA basics

  • What are they? HSAs are tax-sheltered savings accounts available only to those enrolled in a high-deductible health plan (HDHP). An HSA provides tax benefits intended to defray the higher deductibles and out-of-pocket maximum costs of an HDHP.
  • Why use them? In tax-advantaged accounts such as IRAs and 401(k) plans, you can pay taxes up front or defer them—either way, taxes will eventually come due. With an HSA, you are able to never pay tax—contributions and earnings are tax free. The tax savings can compound to produce higher returns than those available from other accounts.
  • How to use them? How best to use an HSA depends on how much clients can afford to save. If they have enough savings ability, it’s best for them to treat their HSA as a long-term investment. In other words, they should pay for current medical expenses out of pocket. The more limited their ability to save, the more complex the decision.

It's difficult to overstate how powerfully an HSA can augment an individual's saving power, through the combined effects of tax-free contributions and compounding when invested.

While the funds are earmarked for qualified health-related expenses, in practice they can be used at any time for any purpose—provided the account owner has receipts for qualified health expenses that offset the withdrawal amount. Any individual health expense can only be claimed once. Therefore, accurate and organized recordkeeping is paramount. Note that withdrawals without offsetting, qualified expenses are subject to ordinary income tax and a 20% federal penalty tax for those under 65.

So theoretically, a client could withdraw HSA money—tax-free—to pay for a semester of a child's college tuition, or for emergency house repairs. The only requirement would be to have enough documented, qualified, health-related expenses to offset the distribution amount.

Over the years individuals move, throw things away, and inevitably lose track of items they don’t use on a daily basis—such as deductible receipts. As an advisor, you can add significant value by helping clients to digitize and securely archive eligible health-related receipts (along with other important financial information).

Taxes now, taxes later, or with an HSA, maybe never

*Distributions must be offset by qualified expenses.

Notes: When taking withdrawals from a tax-deferred retirement plan before age 59½, you may have to pay ordinary income tax plus a 10% federal penalty tax. This table does not address nondeductible contributions made to a traditional IRA or employer plan.

Source: Vanguard.

The favored tax status of HSAs can boost long-term saving

$1 of marginal income

Notes: This hypothetical illustration does not represent the return on any particular investment, and the return rate is not guaranteed. Calculations assume a 4% annual real return, a 2% annual income return, a 24% income tax rate, and a 15% capital gains tax rate. Lower tax rates may make the taxable investment more favorable and the difference between taxable and tax-deferred less. Any future changes in the tax treatment of investment earnings or a rate of return that is lower than the assumed rate of return may further affect the comparison. Investors should consider their time horizon and current and expected future tax rates before making an investment decision.

Source: Vanguard.

Clients should be aware of two notable updates to HSA rules:

  • The 2020 CARES Act expanded eligible HSA expenses to include menstrual products and over-the-counter medications that don’t require a prescription.
  • For 2021 the HSA contribution limit is $3,600 for individuals, with an additional $1,000 catch-up allowance for those age 55 and up; for families, the limit is $7,200, with an additional $1,000 catch-up allowance for each eligible participant.