The Health Savings Account (HSA). Maybe the most underutilized form of retirement savings account in the U.S. Often misunderstood, the HSA is commonly misused as a money in, money out, form of payment for qualified medical expenses. The real secret to the HSA is letting the funds flow to the brokerage side of the account. This is where the magic happens. The money can then be put to work earning compounding market returns in low-cost index funds. With triple tax benefits and decades of growth, this piggy bank will grow very fat to help pay for health care and retirement expenses.
The HSA was established by the Medicare Prescription Drug, Improvement and Modernization Act of 2003. The contribution limit in 2005 was $2600 for individual and $5150 for a family. For 2018, the contribution limits have grown to $3450 for individual and $6900 for a family. If you are 55 or older there is a catch-up contribution increase of $1000 per year. The Affordable Care Act passed in 2010 has led to a large expansion of high deductible health plans and thus an expansion of HSA accounts.
To be eligible for an HSA you must be enrolled in a high deductible health plan (HDHP). This is defined as a $1300 deductible for an individual plan or $2600 for a family plan. As a growing number of employers push the ever rising cost of healthcare onto employees, high deductible health plans are becoming more common. Some employers subsidize this annual deductible by making contributions to your HSA account. For example my employer contributes $1600 to my HSA annually. This very generous employer contribution mitigates a large chunk of the annual insurance deductible should I seek medical care. My HDHP covers an annual physical which is usually all I need for the year. Keep in mind, the high deductible health plans are not for everyone. Generally these plans are considered most beneficial to those individuals or families who are mostly healthy and do not have expensive monthly prescriptions. For example, my son needs a new epi pen every year for his peanut allergy.. This little device is $600 and is not covered by the high deductible health plan pharmacy coverage unless I have met the deductible for that year. Oh, and don’t get me started on why a seemingly simple epi pen device with $1 dollar worth of epinephrine costs $600. That is for another day.
Triple Tax Benefits
In the United States lawmakers make tax advantaged accounts like the IRA or 401k either pretax or post tax. This means you are either going to pay tax on the money before putting it into a tax advantaged account or when you take the money out after decades of growth. Either way, the Federal Government wants some of your money in the form of taxes. The HSA is different. It has triple tax advantage. The money you put in from your employer payroll deduction will reduce your taxable income for that year. The money with then grow tax free. When you get ready to take distributions from your HSA, the money will again be tax free. It almost sounds to good to be true, but it is not.
I will use my HSA as an example because that is what I have experience with. Optum Bank administers my employee HSA. When money is deducted from my paycheck and transferred to Optum Bank it goes into a money market account. I will call this bucket one. This bucket is where I can spend money on qualified health care expenses if I choose to. Bucket one earns a paltry 0.05% interest rate. Yeah! I made that interest rate bold because it really makes me mad that the interest rate is so low. Now to be honest, I did not know the interest rate on bucket one was so low until I just looked it up. Truthfully, I just about spit out my coffee when I saw 0.05%. You know how many people just leave their money in bucket one and never move it to bucket two. Don’t be one of those people. Optum Bank requires that I maintain a $2000 balance in bucket one before I can move any money into bucket two. Any money above my $2000 amount automatically flows into bucket two. Bucket two is my favorite bucket. This is where the magic happens. Bucket two functions almost like a Roth IRA. In bucket two, I have 50 mutual funds and index funds to choose from. Seriously, 50. Some of them are real garbage too.
Here is what you are looking for when selecting investment choices for your HSA.
First you need to look for two options. A low cost index fund or a low cost Target Retirement Fund. The index fund will have the name S & P 500 or Total Stock Market Index fund. If you have one of these funds you are in good shape. Go all in 100% on one of these funds. The expense ratio should be less that 0.25% ideally. The other quality choice is to look for a low cost Target Retirement Fund. This type of fund usually charges a slightly higher expense ratio in exchange for ease of use. You pick a date nearest the year of your retirement and the fund gradually adjusts to be more conservative. The Target Retirement Fund is more of a set it and forget it approach.
Tax Hack #1
Often confused, the FSA and HSA can both be used in the same year. During the open enrollment period of your employer, set up both a Flexible Spending Account (FSA) and a Health Savings Account(HSA). The FSA is similar to the HSA but the money not spent at the end of the year is forfeited. By opening both accounts, the FSA turns into a limited FSA. This means you can only use the limited FSA to reimburse dental and vision expenses. In my case, my children both have braces and my wife wears contacts. These expenses are paid from the FSA leaving the HSA to grow.
Tax Hack #2
Save all of your receipts for medical expenses. Lets go through a scenario.
In 2017 you had $2000 of unreimbursed qualified medical expense receipts. In 2018 your transmission goes out in your car. You now submit your receipts from 2017, take your $2000 and pay for your transmission.
In this way your HSA can function as an emergency fund giving you maximum flexibility.
Open enrollment has long since passed. But next year when November rolls around, set a reminder on your phone. Look into a high deductible health plan, allowing you to partake in the holy grail of tax advantaged accounts, the HSA