The dark chocolate of savings accounts

Like dark chocolate – that magical substance that is not only good for you but tastes great too – Health Savings Accounts are the superfood of investing. And also like dark chocolate, to get the most out of one means understanding the benefits and using it judiciously.

Let’s start with a quick recap of what a Health Savings Account (HSA) is and how it works. If you have a High Deductible Health Plan (HDHP), you are eligible to open a Health Savings Account – think of these two pieces as one of those pendants with two halves that fit together to form one shape meaning it doesn’t make sense to have one without the other. For 2024, a High Deductible Health Plan is one that requires you to pay the first $1,600 (single)/$3,200 (family) of medical costs before the plan kicks in on either a co-pay or a co-insurance (although you’ll probably find that most company plans require a deductible far closer to $3k/$6k these days). The HSA is a savings account you wrap around the HDHP to allow you to save money for those medical costs.

For most plans, the HDHP is the less expensive of the health insurance options so, right off the bat, you have some extra dollars to save into a Health Savings Account (the difference between your current premium and your new premium) and most payrolls will allow you to redirect those dollars into your HSA right from your paycheck. In any given year, if you weren’t able to save the maximum from your payroll deductions, never fear – you can make a supplemental deposit directly into your HSA by writing a check or making a transfer from your checking or savings account.

Of course, having a strong understanding of your medical spending is vital to determining whether or not you should be using a HDHP/HSA but that’s a discussion for another time. What I will say is that the vast majority of people who understand their medical costs and cash flow will spend less using an HSHP/HSA model since the premiums tend to be lower and you get a tax break you wouldn’t with a different health plan.

How are HSAs are taxed, you ask? Well, that’s a pretty short conversation since, used wisely, they aren’t. Contributions to your Health Savings Account are tax deductible which lowers your current taxable income, invested dollars build tax deferred (like your retirement accounts), and distributions from your HSA aren’t taxed as long as they are used for medical expenses (and I’ve yet to meet the person who has absolutely no medical expenses throughout their life).

Unlike Traditional and Roth IRAs, there are no income limits on being able to contribute to an HSA so people who are income-phased out of the IRAs still have a tax-favored savings mechanism. Like the Traditional and Roth IRAs, you can fund your HSA for the previous year up until you file your taxes. If you are over age 55 (and no, I have no idea why the HSA catch-up age is 55 and an IRA is 50…), you can contribute an additional $1,000. In theory, should you be so inclined and eligible, you could fund your IRA AND your HSA AND your company retirement plan and all of those contributions would be allowed.

What’s one planning strategy that only an HSA provides? You could contribute to your HSA account for a number of years, pay for your medical expenses out of pocket, saving all those receipts, then make one big tax-free withdrawal from your HSA to take that special, once-in-a-lifetime vacation and not pay any tax on that distribution. As long as you don’t take out more than the total of all of those receipts you accumulated over the years, that is a perfectly legitimate use of those dollars (fiscally smart is another story…). Maybe it’s not a once-in-a-lifetime vacation but a year of college for your baby girl… Contributing to an HSA can work better than a 529 since you get a federal tax deduction and a broader investment selection than the 529. The average parent puts less than $5,000 a year into a 529 so we’re in the same savings ballpark.

The only significant drawback to using the HSA as a long-term funding mechanism is its death treatment. In a quirk of the tax law, if the beneficiary of an HSA is not your spouse the balance of the account loses its HSA status and becomes entirely taxable to the beneficiary. Strong financial and estate planning once you reach age 65 can mitigate this issue and relatively few people have oversized HSA balances so this is one of those think-tank sorts of situations analysts like to write about to get published but rarely applies to anyone. It’s certainly not a reason to avoid the HSA as an option.

While open enrollment might be months away, now is the time to start looking at your medical spending so you are ready to make a sound fiscal decision when you get to choose between the health plan options this Fall. So, grab an ounce of good quality dark chocolate and build that spreadsheet.