Main Points
- HSAs are great vehicles for tax-deduction, tax-deferral, and a tax-free solution for covering health and medical related expenses, and rollover year over year.
- Offered through qualified High Deductible Health Plans, sometimes privately owned or offered by employers.
- Funds in the account can be invested such that they grow beyond annual inflation.
- Qualified individuals can own these accounts and friends and family can contribute to them.
- Great for people to start in their early career, but places an additional demand on the pocket book.
Have you ever wondered how you might pay medical expenses without directly impacting your pocketbook? There are several strategies – some decent ones like tapping into personal savings, and worse options like taking on debt, pulling from retirement, or hoping to go toe-to-toe with collections and win. For many who have medical insurance with high deductibles, there’s a good chance that your plan qualifies for a Health Savings Account, or HSA.
These accounts were made available back in the Bush administration on December 8th, 2003, to help Americans pay for medical costs in a tax-efficient way. They behave like a strange combination of a 401(k), an IRA, and a flexible spending account (FSA), in that your employer can contribute to it, you can manage the investments, and spend those savings on qualified medical costs1. How to qualify for this type and use of this account varies and depends on several factors, where there are some minor inconveniences and actual cons.
Like any investment plan, HSAs have these pros and cons associated with your ability to save and withdraw for medical needs2. One glaring example is participation in an HSA-qualifying plan, where there is a minimum annual deductible and a maximum out of pocket expense requirement. Medical plans that don’t qualify will not offer these plans, so availability is limited.
Major Benefits
You can think of an HSA as a special kind of tax-efficient investment account. When you open one through a qualifying medical plan, that account belongs to you, even though you do not own an employer medical plan where you are only a participant. This is the most complicated case, and owners of qualified medical plans through private insurers have access to these accounts. If, for whatever reason, you discontinue your medial insurance, it doesn’t spell the end for your investment. These accounts travel with you wherever you are, much like your IRA or 401(k) retirement plans. This is called portability, and it is one of the most important features of any HSA.
Qualified medical plans may have a feature called a Flex Spending Account (FSA), a tax-friendly way to cover medical costs through your plan year. What makes an HSA more beneficial over an FSA is its ability to roll the account value over to the following year. FSAs have a grace period after the first of the new year where you can spend down your FSA contributions on medical-related services and supplies, but it is a use-it-or-lose-it avenue. An HSA will continue to be yours, year over year, and can be rolled over into another employer’s HSA-qualified plan if they offer one. If not, you are able to rollover the amount into your own personal HSA through another servicer. Pretty handy.
Portability is important since medical insurers often provide these accounts with a reduced monthly premium, allowing you to keep more in your bank accounts. But as you contribute to your HSA, your expectation should be that it grows when you’re not using it. Oftentimes, I’ve filed tax returns showing contributions to these accounts only to discover they were sitting in cash and not invested. This is what makes them strikingly similar to retirement plans, and could be a great entry point for many first-time investors. Employer-provided accounts will offer a selection of investments to choose from depending on the servicer they use. These range from conservative domestic mutual funds to aggressive global funds where you can grow your account. If you’re unsure which direction to invest these funds, it’s advisable to speak with a financial professional to determine the path best suited for you.
Beneficial Tax Treatment
Contributions to these accounts are simple. You can contribute to them yourself by payroll deduction (sometimes in tandem with employer contributions), or you can pay into them with after-tax dollars (through your checking or savings accounts). Doing so with after-tax dollars will allow you to deduct contributions from your taxable income, reducing your tax burden. That sounds great, but is limited by the annual contribution limits. For tax year 2025, a single taxpayer buying into an individual medical plan is capped at $4,300, and a married couple under a qualified medical plan with more than one participant is capped at $8,550. If the account holder is 55 years or older, there’s an additional $1,000 catch-up contribution that can be applied for the year.
As we talk about contributions and growth, we need to understand how this growth benefits the account holder. As mentioned before, contributions can be deducted from taxable income, but as the account grows, the taxes on the gains are deferred until you request a withdraw. This tax is only applied if these funds are not used for medical expenses, or if the medical expenses are not qualified. Unless the account holder is under 65 years of age, an additional 20% penalty is applied to the withdraw amount. Ouch.
Contributions are also pre-tax. This is especially true for employer HSA-qualified plans taking payroll deduction. This gives your money a bigger bang for your investment buck. You basically don’t pay tax on the amount contributed, which allows you to keep more of your take-home pay. Your employer has the opportunity to contribute to your account, as do others. Let’s say that your child has started their career and has opened an HSA. You would be able to contribute to their account, and your child can receive the deduction on their taxes. Your neighbor, friend, or complete stranger can contribute to your child’s account, provided it’s not overcontributed.
Distributions from these accounts come out tax-free! That’s impressive, especially if these funds cover costly and unexpected medical events. The tax-free aspect applies to all amounts withdrawn, including contributions and account growth. Most HSA servicers make it easy for account holders to withdraw funds by offering a debit card. Not all servicers provide this and the process can be a little clumsy, so it’s important to have access to a debit card for these purposes, especially if you manage your own away from a medical plan.
Downsides and Hurdles
To address the elephant in the room, your HSA can work for you if you have your account invested. Many employers that offer these normally have them established such that contributions only apply to the cash account with minimal growth potential. You need to be responsible for investing your account to take full advantage of the tax savings, but it does open your account value to market risk. Market risk is the moment-to-moment fluctuation of the value of a given security, whether it’s a stock, exchange-traded fund, or a mutual fund. Depending on how aggressively your account is invested, there could be periods of time where your account value falls below your contributions. On the flip-side of that coin, the same account has the potential for growth. The question becomes: “What percentage of market downside can I stomach for the possibility for growth?” If you don’t like a lot of fluctuation, then your expected return is likely to be lower, and vise-versa.
A small downside would be the contribution limits described before. It’s hard to aggressively save in one of these accounts, especially when you’re mid-career or about to retire. There are other avenues to use retirement savings for medical costs that don’t slap you with a 10% penalty for early withdraw, but you have to pay the taxes on the growth. If you are young in your career and have minimal medical costs, this is the time to max out the contribution limits.
For example, brushing aside the sentiment that the young won’t be able to retire, let’s pretend that a 27-year-old woman works for a company that provides both a qualifying medical plan and the option to open an HSA. And let’s suppose that she expects to retire at 65 (though she’s only able to contribute up to 64½)3, providing at least 37 years of investing. In 2025, her maximum contribution limit is $4,300, and this limit increases over time, but we’re going to assume that she contributes this amount each of the 37 years. Sitting in cash, that amount would be $159,100. Inflation will chew at that amount over time, but if invested to keep with inflation, the amount would grow to $256,855 in future dollars. Now, she sees this and expects a better return, especially since medical costs rise over time. She is a wise investor, so she invests moderately aggressively and attempts to maintain 8% growth year over year to grow her balance and outpace inflation, bringing her real rate of return to 6%. At this rate, her expected balance at age 64 would approximate $870,000, including inflation. With those kinds of funds, she could easily pay for medical expenses and long-term care insurance premiums, should she need it. If not, she could withdraw those funds for retirement once she turns 65 years old, only to pay tax as ordinary income.
This example sounds great, but has a few elements we assume. First is that she’s able to aggressively save this amount each year. Young professionals aren’t just learning their job: They’re trying to live life, find stable housing, cover major expenses, save for big purchases, among other things. Having access to an account like this is great, but only works if contributions are made. The other barrier is that these accounts usually fall to the bottom of anyone’s priority list. More emphasis is placed on funding retirement plans and achieving the American Dream, and many youths retain this ten-foot-tall-and-bulletproof mentality, making saving in this way seem frivolous, if not outright pointless. Another disadvantage is the inability to see the future. We have insurance in most areas of our lives because we can’t look into the future. Planning for medical events is very difficult, even if you manage chronic illness. Even so, illnesses and accidents are, by definition, unplanned. Investing aggressively in an account like this is counterintuitive if you expect funds to be available and minimally affected by market loss. It requires the account holder to take a hard look at their lifestyle and habits, determine their current healthcare needs, and calculate the cost of healthcare in years past. It can take quite a bit of due diligence and the right conditions to get it right, but once you’re on a contribution schedule, all that’s left is account maintenance.
In Closing
These accounts have an extraordinary benefit to those with access to them. Beyond the “triple tax advantage,” they can prevent you from dipping into other savings you have earmarked for your home, lifestyle, and retirement. It’s important to realize that the benefits outweigh the inconveniences, and while HSAs are not accessible to all, there are similar avenues to invest to achieve some of the same goals. When you plan your taxes or retirement, and you hold one of these accounts, make sure you talk with a financial or tax professional to determine appropriate contribution amounts and the risk you can tolerate. Healthcare is not something we like to think about, but building a savings plan as a contingency will go a long way to ensure you can live a little more and worry a little less.
Tree City Tax is accepting new clients for the upcoming filing season, including small business returns. You can book a consultation by calling at (330) 539-4231. Small businesses that schedule a consult before the end of the year reduce their likelihood of filing an extension.
- Publication 502 (2024), Medical and Dental Expenses, IRS: https://www.irs.gov/publications/p502#en_us_2022_publink1000178852
- Investopedia: https://www.investopedia.com/articles/personal-finance/090814/pros-and-cons-health-savings-account-hsa.asp
- Understanding HSA-Eligible Plans, HealthCare.gov: https://www.irs.gov/publications/p502#en_us_2022_publink1000178852