How to Maximize Your HSA

It’s open enrollment season, which means it’s a good time to talk about the Health Savings Account (HSA). HSAs are the most overlooked and underutilized investment vehicle there is.

What is an HSA?

An HSA is a tax-deferred savings vehicle for health expenses. It is triple-tax advantaged, which means:

  1. Your contributions are pre-tax
  2. The money in the account grows free of taxes
  3. Your withdrawals for qualified medical expenses are tax-free

So you can avoid federal income tax altogether on HSA withdrawals for qualified medical expenses.

Typically your HSA will have a minimum amount (usually $1-3k) that you need to keep uninvested. You can invest everything on top of that. The HSA provider chooses a limited set of investment options (similar to a 401k).

If you make withdrawals from your HSA for anything not considered a qualified medical expense, you will pay ordinary income tax on the withdrawal, plus a 20% penalty if you’re under the age of 65.

Am I eligible for an HSA?

An HSA is only available to those enrolled in a high deductible health plan (HDHP).

Most employers will have an HSA provider they utilize. You can typically contribute to the plan via payroll deduction, which avoids FICA taxes (another big advantage of HSAs).

Why is an HSA so powerful?

You get a big benefit from an HSA just by using it for your medical expenses. However, to truly maximize your HSA, you need to take a different approach.

There is a little-known fact about HSAs that makes them super powerful: You can reimburse yourself in the future for medical expenses incurred after the HSA was opened.

For example, let’s say I first opened the HSA in January 2022. In February 2022, I need surgery and get a $2,000 bill from the doctor. If I pay that $2,000 bill out of pocket, I can reimburse myself $2,000 from my HSA at any time in the future. I just need to have the receipt available in case of an IRS audit.

The reason this fact is important is that you can keep the money in your HSA invested and growing, rather than needing to pull it out whenever a medical expense occurs. The growth inside your HSA becomes additional money available for future tax-free withdrawals.

So while the HSA is open, I like to view the medical bills paid out of pocket as tax-free withdrawal coupons from my HSA. And these coupons never expire.

For 2022, the annual HSA contribution limit is $3,650 for employee-only coverage and $7,300 for family coverage. If you are over the age of 55, you can contribute an extra $1,000/year.

By maxing out your contributions and investing the balance, you can amass a sizable balance in your HSA, potentially more than you’ll ever need for medical expenses. In that fortunate case, at age 65 your HSA becomes just like an IRA. Withdrawals for expenses not considered qualified medical expenses are taxed like ordinary income, and there is no penalty.

The Optimal HSA Strategy

If you can afford to do it, you will get the most out of your HSA by paying out-of-pocket for your medical expenses. Keep the required cash balance in the account and invest everything on top of that. Keep your medical receipts (either scan and store them electronically, use an old-fashioned filing cabinet, or, ideally, both) and redeem them in the future for tax-free withdrawals from your HSA.

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