Life Lesson #22: Optimizing benefits – the Health Savings Account (HSA)
I’m a germophobe. This is especially challenging with two young children whose fingers are invariably stuck in their noses and mouths half their waking hours.
Kids get sick – a lot, which means parents get sick. And this vicious cycle can easily lead to expensive doctor visits. With more employers offering Health Savings Accounts, it’s important to know how to optimize this often misunderstood benefit.
The Story: In order to properly introduce this story, we’ll need to get a little up close and personal. My fellow germophobes will relate to what I’m about to share all too well.
When using a public restroom, there are a series of critical steps that must be followed to ensure a “safe” retreat. In the name of brevity and sensitivity, I’ll skip forward to the hand-washing stage.
If the faucet requires handling, this must be addressed with either an elbow or paper towel. It’s also paramount that the paper towel be folded to a sufficient thickness so as to avoid “bleed-through” contamination, which would trigger a mandatory rewash.
The door should now be the only obstacle that stands in the way of a germ-free exit.
Following the same paper-towel protocol, simply open the door without touching flesh to handle. If paper towels aren’t available and have been substituted with a jet-air dryer – G_d help you.
In the real world, it’s usually not that simple, as there are a multitude of scenarios that can make the exit more challenging. But this story is not about exploring those trickier situations.
At the office a few years back, directly ahead of the Christmas holiday, I was washing my hands in the restroom when a coworker began talking with me. As we walked toward the exit together, I had the customary wad of paper towels in my hand, fully prepared to safely open the door. However, he slipped ahead of me and appallingly opened the door with his bare hand.
As we stood in the hallway outside the restroom, he wished me a wonderful Christmas break; and in what seemed like slow motion, extended his hand out toward me.
It felt like I had just been transported into an awkward moment in an episode of Seinfeld.
I stared down at his ghastly, germ-ridden hand as nervous thoughts raced through my mind.
Could our working relationship recover from a handshake snub? Could I explain why I can’t shake his unsanitary hand in a way he would understand?
My brain quickly plowed through a myriad of reasons I could use to tell him why I could not shake his hand. But they all seemed weak and disingenuous. And so, hobbled by a will that was now clearly broken, I grasped that unsanitary appendage in a muted gesture of friendship.
And after a short lap around the office to avoid suspicion, I reentered the restroom to thoroughly wash my infected hand.
The Breakdown: The rational part of me knows I‘m unlikely to get sick by shaking somebody’s hand or touching a door handle. But the fact that I regularly see people use the bathroom, skip hand washing and then touch that very same handle is reason enough to take extra prophylactic measures.
Nevertheless, we all eventually get sick or face medical emergencies that necessitate a trip to a doctor or hospital. How we treat the bills from those visits can have an enormous impact on our financial well-being.
The Health Savings Account (HSA) was first introduced about 15 years ago. Yet, many are unfamiliar with how to take advantage of its powerful benefits and make it a valuable part of their financial portfolio.
So what makes a Health Savings Account so special?
In a nutshell, it may just be the best tax-shielded investment vehicle readily available. It effectively combines the pre-tax advantages of a traditional 401K with the tax-free growth benefit of a ROTH IRA.
What does all of that finance gobbledygook mean exactly?
It means money goes into an HSA tax-free, grows tax-free, and can also be withdrawn tax-free. It’s a tax-savings trifecta! And as if that wasn’t enough, it also offers additional flexibility and options that I’ll cover below.
Not to be confused with a Flexible Spending Account (FSA), HSA contributions rollover without forfeiture risk and have much higher contribution limits. The 2019 HSA contribution limit for an individual is $3,500 and $7,000 for a family. Additionally, if you are 55 or older, you can increase those thresholds with an additional $1,000 catch-up contribution.
Some employers also offer incentives if you opt for a high-deductible HSA plan over a traditional health insurance plan. This could look something like a $1,500 bonus contribution for a family, which would apply toward the $7,000 annual limit.
In marketing this bonus, employers often tout a reduced maximum out-of-pocket, as they assume you will be using this incentive to cover your medical costs throughout the year. They even go so far as to send you a “convenient” HSA debit card for easier access to the funds.
And that is exactly what you don’t want to do.
So what should you do to optimize a Health Savings Account?
- First and foremost, prioritize your budget to enable the maximum contribution limit.
- Fund it – In the case of a family, contribute the $7,000 maximum, about $269 per pay period if paid biweekly (assuming no employer HSA incentive bonus).
- Set up payroll deductions if your employer offers this option.
- HSA contributions made through a payroll deduction bring the added benefit of avoiding the 7.65% FICA taxes. Moreover, the income tax benefit is realized immediately instead of when you later complete your tax return (see step 8).
- Do not use the HSA account to pay for any medical related expenses throughout the year.
- This effectively means you’ll need to be able to cash flow the $7,000 contribution (ignoring tax savings), as well as any medical expenses incurred up to your maximum out-of-pocket each year.
- Save receipts for all qualified medical expenses.
- Elect an investment account for your HSA.
- Investments are typically not allowed until a minimum account balance has been met.
- Invest HSA balance and future contributions into low-cost index funds.
- If you don’t have a payroll deduction option, claim $7,000 HSA deduction when preparing income taxes (Form 8889 and Schedule 1 Form 1040).
Assuming a 24% federal income tax bracket and payroll deduction option, you could reach the $7,000 maximum by self-funding only $4,785. The savings are further amplified through deductions on most states’ state-income taxes (but watch out for CA and NJ).
In addition to the pre-tax benefits, the real magic happens with compound interest. Assuming an 8% annual growth rate, $7,000 invested annually over a 30-year career approaches $800,000. That’s over five and a half times the original $144,000 pre-tax investment. Moreover, you also wouldn’t pay any taxes on the near $600,000 of investment gains when used for qualified medical expenses, which brings us back to step 5: Save receipts.
So why should you save receipts if you aren’t supposed to use the HSA account to pay for medical related expenses?
The answer lies in delayed distributions. There is currently no time restriction on when you first incur a medical-related expense and when you must take a tax-free distribution from your HSA account related to that expense. Consequently, saving these receipts gives you potential future access to these tax-free funds without penalty. That open-ended optionality is an extremely valuable benefit.
What if you have all-star genetics and never need medical attention (probably because you also avoided touching restroom door handles)?
No problem! After you reach the age of 65, the funds are available for non-medical-related expenses without a 20% withdrawal penalty. The caveat is that the distributions would be treated like a pre-tax 401K, effectively forfeiting the after-tax withdrawal benefit – a small price to pay for a medical history that signals virtual immortality.
You may have noticed many public restrooms have a trash bin strategically located next to the exit. That’s because sensible people refuse to grab the handle unprotected. If only we treated our finances with the same degree of prudence. While a little hand sanitizer can erase 99.9% of illness-causing germs, it can’t make up for an $800,000 missed Health Savings Account opportunity.
Remember, you can’t afford to grab a public restroom door handle with your bare hands, just like you can’t afford to ignore the enormous benefits of an HSA.
Great post. If I understand correctly, saving receipts just means you let the money in the HSA grow tax free (until 65) and you can then access that money later by “cashing out a receipt”. Question: Why is that better than paying those expenses with HSA dollars already earned and letting that equal amount of money grow in an alternative account?
Nm… Because the point is the income on that growth in HSA is not taxed.
The age of 65 is irrelevant unless you and your family never have any health issues that necessitate medical intervention. The money grows tax free as long as it is ultimately used to cover a medical-related expense, irrespective of age.
The receipts just give you flexibility in the event you need or want access to those funds without incurring taxes and penalties.
Hypothetically, decades from now you could have a need for cash, and the HSA could possibly be the best place to withdraw that cash from if you had maintained your receipts.
The receipts simply just keep the option on the table, assuming tax laws don’t change. And options and flexibility are a great thing.
BTW, FWIW… I also use a towel or my shirt to open bathroom doors! A tradition passed down from my grandfather 🙂