The Roth IRA’s More Powerful Younger Brother

The Health Savings Account

What is an HSA?

In 2003, the American healthcare system was changing towards consumer driven plans and many high deductible health insurance plans (HDHP) started emerging. Due to these high deductibles, there was a need for people to pay for medical expenses seamlessly, so the Bush administration created health savings accounts (HSA). HSAs are special accounts designed to be used only for medical related expenses.

Who should get an HSA?

In order to qualify you must be under 65 years old and enrolled in a high deductible health insurance plan (HDHP) either through your employer or individually. Because these plans are so intertwined with HDHPs, in my opinion, they are only ideal for young and healthy individuals who do have significant out-of-pocket medical expenses. Otherwise, it doesn’t make sense since having lower deductibles is more vital than gains from an HSA.

How it works?

HSA accounts are really powerful because they are triple-tax leveraged. The money that goes in is pre-tax, the money grows tax free, and withdrawals are not taxed.

Each year you are allowed to contribute up to an IRS determined limit; for example, in 2021 the individual limit is $3,600. Your employer should offer automatic deductions into the HSA. And sometimes employers will match contributions, however the total contribution has to be within the limit. Once the money is the HSA, you can invest the assets in stocks, ETFs, mutual funds, etc that are offered by the sponsoring institution (Fidelity, Vanguard, etc).

Withdrawals are interesting. The textbook rules of withdrawals are as follows:

• Funds can be withdrawn anytime as long as they are for qualified medical expenses.
• If funds are not used for qualified medial expenses, they will be taxed as ordinary income and the IRS will impose a 20% penalty.
• After you reach age 65 or if you become disabled, you can withdraw funds without penalty but the amounts withdrawn will be taxable as ordinary income.

My HSA account came with a debit card that I could use when paying for medical expenses. After using it two times I realized I was doing it “wrong.”

Because of how powerful they are as investment tools, it actually doesn’t make sense to use HSA funds (if you don’t have to). It’s more beneficial to let those assets grow over time, and withdraw after the age of 65, because you reimburse yourself for medical expenses in any previous year, as long as the expenses were incurred after your HSA was established.

What I do now is keep a spreadsheet of all of my medical expenses and a copy of receipts. I’ll simply reimburse myself in the future and let my HSA funds grow tax-free. There might be some apathy towards the spreadsheet approach, but I think it really maximizes the value HSAs can provide and is therefore worth it.

Closing Thoughts

Other than the HDHP requirement there aren’t any other disadvantages to HSA accounts. I know I’ll continue to have an HDHP for a few more years, until a lower deductible plan makes more sense.

P.S. This is not financial advice and I am not your financial advisor.