Get Triple Tax Benefits With a Health Savings Account — and Avoid My $125,000 Mistake

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A photo of Kenneth Chavis IV Courtesy of Kenneth Chavis IV
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My biggest money mistake was not contributing to and investing in a health savings account (HSA) three years earlier. This haunts me every fall during open enrollment season, which many people are now in the midst of.  

I’ve calculated that this mistake will cost me $125,000 in tax-free investment growth when I am 65. 

An HSA is a special-purpose investment account that you become eligible for based on your health insurance plan. This account offers triple tax benefits when funds are used for qualified medical expenses. 

In the three years I could have contributed to one, but did not, the total contributions I could have made was about $9,000. Assuming the $9,000 were to grow at a 7% annualized rate for 40 years, this would have grown to over $134,000 — a $125,000 net difference, all completely tax-free. 

The reason I did not contribute to an HSA during those three years was because I was unsure about enrolling in a health insurance plan that had the potential for high out-of-pocket costs if I ended up needing significant medical care. This is a requirement to become eligible for an HSA. 

I remember thinking at the time, “What happens if I’m in an accident or need a significant procedure?” So I decided against it. 

In hindsight, this was a mistake. Considering my age, health and lifestyle at the time, the long-term benefits of an HSA outweighed the potential costs of a higher deductible. 

 Here’s why.

What Is a Health Savings Account (HSA)?

An HSA is a tax-advantaged investment account you can use to pay for medical expenses. 

Like a 401(k), you contribute pre-tax money, which gets you a tax deduction. Once your contribution is made, you can choose to keep the funds as cash or invest them. If you invest the funds, you won’t pay federal income taxes on the growth. Most states also won’t tax the growth, although some states (like California) will. 

When the funds in an HSA are used for qualified medical expenses (a broad range of items), the distributions are also exempt from federal income tax and state income tax in most states. 

To qualify for an HSA, you must have an eligible high deductible health plan (HDHP) and meet a few other conditions.

If you qualify for an HSA, you can easily open one at a bank or investment institution. Your employer will likely have an institution to refer you to if you have your health insurance plan through work.

The Three Tax Advantages of An HSA

Understanding how the HSA tax benefits work will help you maximize your tax savings and avoid unnecessary penalties:  

1. Tax-free contributions

If you’re making contributions through your employer, they’ll take it off your pre-tax income (both federal and state, if your state recognizes HSAs). If you’re contributing independently, you can deduct the amount from your taxable income.

The IRS has capped the 2022 contributions at $3,650 for individuals and $7,300 for families. Those over 55 can make an extra tax-free contribution of $1,000 for the tax year. For 2023, the IRS will raise the contribution limit to $3,850 for individuals and $7,750 for families. 

2. Tax-free account growth

Once your account reaches a certain balance, you can invest your savings in a menu of options — mutual funds, stocks, ETFs and other investment vehicles

Best of all, your account growth and any investment income will be tax-free on the federal level and likely on the state level! And your HSA balance gets carried forward every year.

Most institutions that provide HSAs require you to reach and maintain $1,500 – $2,000 before you’re allowed to invest. But, this may vary depending on your HSA provider.    

3. Tax-free withdrawals for qualifying medical expenses

Qualifying expenses can include dental treatment, eyeglasses, hospital services, and many other healthcare-related costs. Be careful not to withdraw funds for non-qualifying expenses. You will pay income tax and a 20% penalty on such withdrawals if you’re under 65 and are not disabled.

Pro Tip

The IRS allows a tax-free rollover from an IRA to an HSA once in your lifetime. Consider rolling over pre-tax funds from a traditional IRA if you plan to use those funds for medical expenses now or in the future. Doing so will let you withdraw money from your traditional IRA before retirement without taxes or penalties, as long as you use the funds for qualified medical expenses.

You can roll over an amount up to your maximum HSA annual contribution limit ($3,650 for an individual, $7,300 for a family, and an extra $1,000 if you’re over 55). The limit covers any rollover as well as your new HSA contributions for the year, meaning if you roll over $3,000 from your IRA, you can only make $650 in new contributions for the year. You also can’t deduct the rollover amount from your taxable income.

To qualify for a rollover, you must be eligible for an HSA and remain that way for another 12 months. If not, you will pay income tax and an additional 10% on the rollover.

Get advice from a tax professional to make the best decisions that maximize the tax-free benefits of your HSA.

Best Way to Use Your HSA

The best way to use your HSA is to not use it — for a very long time. 

Yes, you read that right. Here’s why:

Because your HSA is triple tax-advantaged — pre-tax contributions, tax-free growth and income, and tax-free withdrawals when used for qualified medical expenses — you should allow your HSA to continue compounding and growing tax-free for as long as possible!

This means you should delay using your HSA as much as possible for medical costs today, so that it can grow for when you really need it in the future. 

Consider a couple of examples:

Example A

Assume you have $3,000 in your HSA today and contribute $3,000/year for the next 30 years. Assuming your HSA grows at an annualized rate of 7%, your HSA would grow to over $306,000 in 30 years.

Example B

Assume you have $3,000 in your HSA today and contribute $3,000/year, but also use $1,000/year for medical expenses for the next 30 years. Assuming your HSA grows at an annualized rate of 7%, your HSA would grow to over $211,000 in 30 years.

In this example, the total amount you’ve used from your HSA for medical expenses over 30 years is $30,000, but this resulted in a difference in your HSA balance of $95,000!

This highlights the power of allowing compounding and tax-free growth to work for you over the long term. 

That is something that I wish I would have leaned into more when I was just starting my career!

Am I Eligible for an HSA?

To be eligible for an HSA, you must meet the following requirements set by the Internal Revenue Service (IRS):

  • Have a high deductible health plan (HDHP) that meets the following requirements in 2022:
    • Minimum deductible: $1,400 for individuals and $2,800 for families.
    • Maximum deductible + out-of-pocket expenses: $7,050 for individuals and $14,100 for families. 
  • You must not have another health insurance plan, such as through a spouse’s coverage, Medicaid, Tricare, etc. Some exceptions include coverage for accidents, dental care, and disability. 
  • You must not have a Medicare plan. 
  • Someone hasn’t claimed you as a dependent on their last year’s tax return. 

An HSA Isn’t for Everyone

While I regret not contributing to and investing in an HSA sooner, HSAs aren’t the best choice for everyone because of the high deductible health plan (HDHP) requirement.

These health plans have a minimum deductible of $1,400 for individuals and $2,800 for families, which means you have to pay at least this amount out of pocket before your health insurance begins to pay for certain covered medical services. 

In some cases, these health plans may even lead to a greater financial burden, depending on your age, health, medical history or lifestyle. 

If you are one of the following, opting for an HDHP instead of a lower-deductible plan may result in a greater financial burden:

  1. Older individual (statistically more likely to have or develop chronic health conditions)
  2. Individual with existing chronic health conditions that require expensive ongoing treatment
  3. Someone who may get into a serious accident and/or have an unexpected medical emergency 

Studies have also shown that HDHPs can incentivize lower-income patients to avoid preventative care (if it’s not fully covered under the plan), which can lead to future problems.

Typically, HDHPs are best for healthy, young people who are unlikely to need to see a doctor beyond the basic preventative care visits that are fully covered by the HDHP, or those who are in a strong financial position and don’t expect major medical expenses each year. 

It’s important to remember that deciding what health insurance plan is best for you is a personal choice that should take into account your personal health needs as well as the financial implications. Be sure to compare all the healthcare plans available to you so that you make an informed decision. 

And if you decide an HDHP is your best option, then by all means, maximize it with an HSA.