Why You Should Consider an HSA Even If You're Not Rich

If you're looking into tax-advantaged ways to save money, you need to consider a health savings account (HSA). An HSA has a unique triple tax benefit:

• Your contributions reduce your taxable income
• Any investment growth within the account is tax-free
• Qualified withdrawals (that is, ones used for medical expenses) are tax-free

Another key advantage of having an HSA is that the balance doesn't disappear at the end of the year. Rather, it rolls over in the following year for you to use.

How HSAs Work

To be eligible to contribute to an HSA, you must be enrolled in a high-deductible health plan. That means a plan with a deductible of at least $1,600 for an individual or $3,200 for a family in 2024. The amount you can deposit changes from year to year.

For 2024, the limits are $4,150 for individuals and $8,300 for family coverage. People age 55 and older can make catch-up contributions of $1,000 per year. Married couples need to have separate HSA accounts for each spouse. Joint HSAs are not permitted.

Any money left unspent in the account rolls from one year to the next. If the account earns interest, the earnings are tax-free. Some employers contribute a portion of the amount paid into the employee's account. These additions count toward your contribution limits.

If You Sign Up Mid-Year

These numbers assume you sign up for the HSA at the start of the year. If not, the math is simple. Annual contribution amounts are prorated for people who join the plan after Jan. 1 of any year. If you sign up later in the year:

• Divide the annual contribution limit by 12
• Multiply that amount by the number of months you are eligible for the plan

An individual who joins a plan at the end of June 2024, for example, would be able to contribute $2,075 (half the annual limit of $4,150).

The Last-Month Rule

There is a way to contribute the maximum even if you are eligible for an HSA for less than the full year under the so-called last-month rule.

According to the Internal Revenue Service (IRS), if you are eligible for a plan on the first day of the last month of the tax year (Dec. 1 for most people), you are considered eligible for the entire year, which means you can contribute the HSA maximum.

But you must remain eligible for the HSA for the next 12 months, or else the contribution limit under the last-month rule is prorated, with the excess contribution subject to income tax along with a 10% penalty (unless you become disabled or die.)

Taking the Tax Deduction

The entire amount deposited is tax-deductible on returns for that year, even for filers who do not itemize deductions. Payroll deductions are made with pretax dollars, reducing the employee's gross income. Employer contributions are deducted from taxable income by the employer, so they do not need to be itemized by the employee.

Using the Money in the Account

HSAs can be used to pay for a wide-ranging list of qualifying healthcare expenses. These include prescriptions, doctor visit copays, mental health and addiction treatment, dental care, and vision care.

The list also includes the costs of alternative healthcare treatments such as acupuncture or chiropractic services. Fertility treatments, smoking cessation programs, service animals, and long-term care insurance premiums all are covered, as are many health-related products.

The IRS periodically updates its list of allowed (and not allowed) expenses. IRS Publication 502 has the current list and most insurers provide their customers with one.

Note: You can withdraw money from your HSA for any reason. It's your money, after all. However, if the expense isn't on the IRS-approved list and you're not at least age 65, you'll owe taxes and possibly a 20% penalty for the withdrawal that year.

No Expiration Date

There is no deadline with HSAs. The money rolls over into the following year. This is unlike the flexible spending account (FSA), which follows the use-it-or-lose-it rule. This means it expires at the end of the year. Certain employers may allow you to carry over a certain portion into the next year ($610 from 2023 to 2024 and $640 from 2024 to 2025) or offer a grace period of up to 2.5 months for the full amount.

HSAs are also portable and stay with you even if you change jobs. This makes the HSA a great savings vehicle even for the youngest and healthiest people, who may face increasingly expensive medical care in future years.

A bonus benefit is that the account owner, after the age of 65, may take distributions from the HSA for any purpose, health-related or not. They will pay regular income tax but no penalty on withdrawals for non-medical costs.

Benefits of an HSA

HSAs can benefit many taxpayers, especially because a typical couple turning 65 in 2023 will pay an average of $315,000 in out-of-pocket medical costs during their retirement years, according to a study by Fidelity. With that in mind, investing the money in the HSA account may be the best course.

Money In Your Account Can Be Invested

Account holders who invest some of the assets in their accounts tend to have significantly higher average balances, according to the Employee Benefits Research Institute. Investors also contributed more than those who didn't invest their HSA balances. But only 12% of HSAs were invested as of December 2021.

For example, a 55-year-old who contributes the maximum individual rate of $4,150 to an HSA every year until age 65 can expect to contribute $41,500. But if this money is invested at a 5% rate of return without taking distributions, the actual amount by the end of that period will be over $52,000

Starting earlier is even better. A high-earning 45-year-old who saves the limit for families of $8,300 each year will save $166,000 in an HSA by age 65. If that money has been invested at a 5% rate of return, the final balance at age 65 will be above $270,000.

Of course, an HSA is not intended primarily as a retirement savings vehicle. It's there so that you can cover out-of-pocket medical costs from year to year. But it's worth considering, as each unexpected medical bill arrives, whether you should tap into your HSA or preserve the tax-deferred savings for a potentially greater need down the road.

Tax Savings Every Year

Millennial entrepreneurs take note: Someone in the 28% tax bracket who began contributing to their HSA at age 25 and earned a 7.5% rate of return on the account could save nearly $350,000 in federal income taxes.

Another big advantage is the savings on medical expenses. Let’s say you're taxed at a 36.4% federal income tax rate. You’d have to earn $4,716 to pay for a $3,000 medical procedure such as laser eye surgery, but just the pretax $3,000 if you use an HSA. (Note that HSA contributions are generally subject to state tax.) That’s a savings of $1,716.

Who Benefits Most From Having an HSA?

The short answer: nearly everyone. You don't need a high income to benefit from an HSA, says Carolyn McClanahan, a certified financial planner and founder of Life Planning Partners in Jacksonville, Florida. Even if you're unable to contribute the maximum amount allowed, "there is value in putting anything away, and little savings add up," McClanahan says.

This is especially true for younger people, she notes, since getting into the habit of taking advantage of an HSA can be a good way to form good savings habits.

Something to keep in mind, McClanahan says, is that high-deductible health plans, which you must have in order to be eligible for an HSA, have changed a lot. "The copay plans used to be a better deal, but now I think they’ve constructed them so they’re not," she says.

Even a person with significant health issues might find that a high-deductible plan, coupled with the ability to save tax-free in an HSA, is a better deal. "Where people get into trouble is if they have a really high deductible [they can't meet]." In that case, they need to either save up that money in the HSA or choose a plan with a lower deductible.

Choosing an HSA Administrator

If you don't have an HSA through an employer, you can open your own account through many financial institutions. The options have improved over the years, so you can shop around for the best HSA administrator for you.

That means an institution that offers investment options that match your risk tolerance.

Even if you're self-employed, you can reduce your taxable income by paying health insurance premiums out of pocket and saving the HSA funds for the future.

Who Benefits Least From Having an HSA?

People who have a lower income can benefit from having an HSA, if they can manage to stash at least the amount of their insurance deductible in the account.

McClanahan recommends funding the account every year. "If you don’t use it, it builds up," she notes.

If money is really tight, you need to run the numbers. If your health insurance costs are subsidized through a state or federal Affordable Health Care Exchange website, you may not have an urgent need to save even more for your health care costs through an HSA. Those subsidies are even more generous, at least temporarily, through the American Rescue Plan Act passed in response to the COVID-19 pandemic.

The American Rescue Plan Act increased premium tax credits for all income brackets for coverage years 2021 and 2022. Most participants in health care exchange plans across all household income levels paid lower premiums as a result of tax credits provided by the legislation. These tax credits were extended by the Inflation Reduction Act in 2022.

The factors to input into a calculator are the cost of premiums, compared with those of a lower-deductible plan with higher premiums; whether your employer is contributing anything to the HSA—that's free money—and the total of any regular, expected healthcare costs, not including annual wellness visits and preventive care, which incur no out-of-pocket costs under a high-deductible plan.

Some Affordable Care Act plans are not HSA-eligible: The plan will state whether it can be used with an HSA.

The Bottom Line

Even if you're maxing out your 401(k) plan or IRA contributions, you shouldn't ignore the advantages of saving a bit more on taxes in a health savings account.

That triple tax advantage makes it an excellent choice for putting away a bit of money for your health-related needs. You can use it immediately if you need to, or you can let it grow into a tidy sum for your retirement years.

As they have grown increasingly popular, many more options are available, especially for people who want to invest money in order to add some tax-free profits to their healthcare nest egg.