Are You Making These 3 Mistakes With Your Health Savings Account?

What if I told you that your next car could be paid for with pre-tax dollars in a tax-free, penalty-free and totally legal way?

Okay, now I have your attention.

A Health Savings Account (HSA) is one of the most underutilized accounts in personal finance. Some people don’t contribute to it and others do, but spend it each year.

If managed correctly, an HSA is a powerful investment account that can be used to reduce your tax bill now and provide you with the flexibility to use the account throughout your life (and not only post-age 59.5 like most investment accounts).

Here is an overview of an HSA and 3 mistakes to avoid ensuring you are taking full advantage of its power.

What is an HSA?

A Health Savings Account is an account that financial planners nerd-out for. Why? Because it is the only account with triple tax advantages. You are able to contribute up to $3,600 in 2021 if only you are covered on your health insurance or up to $7,200 if you have other family members on your health insurance. These numbers are set by the IRS and go up slightly each year.

So how does it work?

Contributions are tax deductible. Earnings grow tax-free. Withdrawals are tax-free if used to pay for qualified medical expenses or reimburse you for prior qualified medical expenses.

The list of qualified medical expenses is quite robust – you can view them here. It ranges from your typical expenses like co-pays, doctor’s visits, etc. all the way to cold medicine, sleep aids and insect bite creams.

So, what’s the catch? Two things:

1. You need to be on a high deductible health plan which is $1,400 if your health insurance covers only you and $2,800 if you have other family members on your health insurance. A deductible means the amount that you need to pay for medical expenses until coinsurance features kick in (where the insurance company covers the majority of the medical expenses). This means you may pay a higher amount of medical expenses compared to if you were on a lower deductible plan.

2. HSAs carry steep penalties if you don’t use the funds to pay for out of pocket expense or reimburse you for prior expenses. Ineligible withdrawals are subject to a 20% penalty and income tax which is really high.

So, what happens if your medical expenses are really low? Well first, consider yourself lucky because it means you haven’t had any major health issues. Next, an HSA can later be used for things like Medicare premiums and other expenses that may not be applicable to you now. You can also use the account for any reason after the age of 65, but you would owe tax on it if it’s not a qualified withdrawal.

Now let’s move on to the common mistakes people make.

Mistake 1: You are not maxing out your HSA

Most people think that you should always max out your 401(k) first. I’d argue differently. In fact, I believe there are 3 better ways to save before you max out your 401(k).

Yes, it’s important to contribute the minimum amount to your 401(k) to receive the employer match, but after that, I recommend shifting gears to your HSA.

Remember – individuals can contribute up to $3,600 in 2021 and families can contribute up to $7,200 in 2021. This is a significant amount you can save each year. Most people don’t contribute the maximum because they don’t believe they will spend that amount in medical expenses.

Mistake 2: You are not investing your HSA

Rather than spending your HSA, I recommend paying for medical expenses out of pocket and investing your HSA for long-term growth. Remember – contributions are tax-deductible and earnings grow tax free!

If you were to max out your HSA at $7,100 per year and assume 5% investment return, and a 30% total tax rate In 10 years, you would have a $89,303. Now that HSA account balance that contains $18,303 of investment growth. Not only would you save on tax from the $71,000 of total contributions, but you would also save on tax from the $18,303 of investment growth. This equates to nearly $27,000 of tax savings if used for a qualifying withdrawal!

Now, this takes proper cash flow planning to execute. It can be difficult to pay for large out of pocket expenses and it may seem tempting to tap into your HSA.

Mistake 3: You are not documenting your out of pocket medical expenses

Proper HSA planning requires you to track all of your out of pocket medical expenses since the HSA was established (prior expenses don’t count) so you can actually use your HSA in a tax-free and penalty-free way. I call this creating a “medical tab”.

Did you pay a copay? Add it to the tab.

Did you pay for dental work? Add it to the tab.

Did you buy sunscreen? Add it to the tab.

A qualified HSA withdrawal means you are paying for current out of pocket expense OR reimbursing yourself for prior out of pocket medical expenses. The planning strategy here is to build up your “medical tab” so you have documented proof that you are in fact reimbursing yourself for prior medical expenses.

For example, let’s say after 6 years, you have $12,000 of documented out of pocket medical expenses. This means you can withdraw $12,000 tax and penalty free from your HSA balance to “reimburse yourself” for that $12,000 of expenses and then use that money for whatever reason you want.

If you were to get audited, an auditor is going to ask about the HSA withdrawals. That’s why it’s so important to ensure you have proper record keeping when pursing this strategy!

Key takeaways

• This type of strategy requires discipline and proper cash flow planning. You need to weigh the possible higher costs of medical expenses of a high deductible plan with the tax benefits of an HSA.

• Most HSA plans allow you to invest funds after you hit a certain cash amount. If you leave your employer, you can typically roll your HSA to a different financial institution. Schwab HSAs actually don’t require any minimum cash amount, so you can invest the full account.

• Don’t worry if your “medical tab” is low in comparison to your HSA account balance. Your medical expenses will almost certainly be higher in your 60’s so you can view your HSA as a long-term investment account specifically earmarked for medical expenses.

• It is so important to keep clean records. I recommend maintaining a spreadsheet/folder and add to it when things come up, so you aren’t trying to reconstruct the “medical tab” from 5 years ago!