Not to be confused with a Flexible Savings Account (FSA), a Health Savings Account (HSA) is a powerful tool in the finance universe. Often available with select plans from your employer, an HSA is an account used to deduct funds pre-tax from your paycheck. The funds are earmarked for future medical expenses once saved, but in the interim, they can be invested and will grow tax-free. When the funds are used for an eligible medical bill in the future, no taxes are owed either. That’s right: An HSA is triple-tax-advantaged and the only account that is.
As a reminder, a Traditional IRA account is funded using pre-tax dollars, but withdrawals are subject to ordinary income tax. Inversely, a ROTH IRA is funded with after-tax dollars but future withdrawals are not taxed. What makes the HSA special is that you get both benefits on this account. While the requirement to use the funds for medical expenses may seem restrictive, the ability to rollover the funds year to year makes the account a viable tool for supplemental retirement savings; especially since you can invest your savings in the meantime.
There is no deadline for using your HSA funds for medical expenses and here’s what that means: Let’s say this year, you encounter $500 in medical costs, but instead of using your HSA to pay the bill, you pay out of pocket and save the receipts. You then use this same approach for the next ten years. In ten years, let’s suppose you need to withdraw money from your HSA. Because you have receipts that total $5,000 in medical expenses (that you paid out of pocket), you can withdraw up to that amount now tax- and penalty-free. This strategy is not only beneficial, but it’s also completely legal and acceptable. The only catch is you can only consider the medical expenses you incurred after you established the HSA.
This reality makes the HSA the best retirement savings vehicle for individuals who have already taken full advantage of employer match opportunities, are organized enough to save all medical documentation for the long-term, and can budget to save $3,550 (pre-tax) per year; the annual limit on HSA contributions (including any employer match).
Alex, age 25, earns an average salary and pays an average effective federal tax rate of 14.20%. To max their HSA, Alex begins contributing $295.83/month from their paychecks to achieve the annual HSA contribution limit of $3,550 per calendar year. Because these contributions are taken pre-tax, Alex’s wages are only reduced by $253.82/month (because they are not paying income taxes on these funds).
Alex makes this new habit part of their financial plan and consistently maxes out their HSA annually (assuming no increase to the HSA annual limit). During this time, whenever Alex incurs a medical expense, they pay for it out of pocket and never withdraw money from their HSA. All the while, Alex keeps a meticulous record of PDF files documenting all of their medical expenses throughout their life. At age 65, Alex is preparing for retirement. As a result of Alex’s regular contributions to their HSA, a reliable 8.2% annualized return on the funds from being invested in a low-cost total stock market index fund, and the lack of withdrawals for the account’s history. Alex’s HSA is now worth over one million dollars!
Now in retirement, Alex wishes to begin utilizing the funds in their HSA. Over a lifetime, Alex’s well-documented medical expenses were a reliable $500/year, and there is a documentation trail for all of it. Immediately, Alex can withdraw $20,000 ($500 x 40 years)tax-free. In the future, Alex has two choices: Continue to use the funds for all medical expenses (unfortunately, these will be common in Alex’s old age), or withdraw the funds for non-medical expenses and pay ordinary income tax on them, effectively converting the funds to Traditional IRA funds since the money was still able to be deposited and grow tax-free; and Alex will only pay ordinary income tax on withdrawals.