Why I Max Out My Health Savings Account (And You Should Too)

Updated June 14, 2017

When I worked as a 401(k) enroller, my regional sales manager (who happened to be my step-dad) used to demonstrate the tax advantages of the 401(k) by ripping a dollar bill into two pieces to show the effect of taxes on income. He would then go on to say that trying to save for retirement with after-tax money was the equivalent of saving only a portion of every dollar we earned and by putting that money in the 401(k), we got the benefit of the whole dollar instead.

Not only did this grab my attention—unless they are a magician you rarely expect someone to voluntarily rip dollar bills in half—but it drove home the idea that tax-deferred saving was better than saving after taxes.  There was only one problem: that money would eventually get ripped, figuratively speaking, when it was withdrawn in retirement.

But what if there was a way to save money for retirement so that it NEVER gets ripped? Well, such a way does exist—sort of.  It’s called the health savings account or HSA for short.

What is the HSA?

In short, HSAs allow you to set aside pre-tax money for future medical expenses. As long as the funds are used for qualified medical expenses, there is no tax due on the money, ever (i.e., it never gets ripped). If it’s not used for qualified medical expenses, then you have to pay ordinary income tax on the distribution plus a 20% penalty if taken prior to age 65.

Another way to look at this is as if it were a tax-deferred 401(k) with a 20% early withdrawal penalty until age 65 BUT with the added bonus of tax-free distributions if the money is used for qualified medical expenses.

Why it’s a great deal

Now you might be thinking “Ouch! I have to pay taxes AND a 20% penalty if it’s not used for qualified medical expenses?  That doesn’t sound good.”  True, that doesn’t sound good, but let me tell you why that’s probably not as big of a deal as it sounds.

For starters, when do you think your medical expenses will be greater—now or in retirement?  Most people I talk to suspect retirement. If that’s the case, then chances are you’ll always have qualifying medical expenses you can use the money for.

Next, how hard would it be to wait until age 65 before having to withdraw money for non-qualified reasons? For many people, they may not even be fully retired by 65 and for those that are, they probably have other sources of income that can carry them until age 65 if needed. Remember, the funds are tax-free if used for qualified medical expenses at any age but if you are fortunate enough to have good health and low medical expenses, you just have to wait until age 65 to avoid the penalty.

Lastly, there is a little known provision in the tax code that allows HSA owners to use funds to pay for previously incurred expenses as long as the expense was paid for with after-tax money and incurred after the HSA was established.  (If you ever plan to use this provision, you’ll want to make sure you keep good records so that you can show which expenses are covered by your distribution.)

Why I fully fund my HSA even though I have few medical expenses

For these reasons, my colleagues and I prefer to fully fund our HSAs every year. Unlike a flexible spending account, we are not required to spend the money. Instead, we use after-tax money to pay for current medical expenses so that our HSAs can be invested and continue to grow.

HSA eligibility & rules

To establish an HSA, you must participate in a high-deductible health plan. Contributions may be made through payroll deduction or from a checking account. (Contributions made through payroll deduction are netted out of W2 earnings but after-tax contributions made from a checking account may be deducted in the Adjusted Gross Income section of tax form 1040.)

The IRS sets contribution limits for each year and you have until April 15th (or the tax filing date, if different) to make a contribution for the prior tax year. (Annual contributions include employer contributions, if applicable.)

No one likes seeing their money get ripped by taxes, so take full advantage of the tax-free benefits of the HSA.

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