Pursuing Financial Independence
It’s that time of year again when most employers allow their employees to change their insurance plans and benefits.
This year’s open enrollment period will be particularly interesting for me because it will be my first as a married man so I will need to see if it’s worth adding my wife onto my insurance, or vice versa.
Because some of you may be researching health insurance options like I will be, I thought it’d be a great time to talk about America’s ultimate retirement account. It’s not actually described as a retirement account but if used wisely, it could be one of the best places to put funds, not only for standard retirement but also for early retirement.
The ultimate retirement account is better known as a Health Savings Account, or HSA.
An HSA is a tax-advantaged savings account available for people who are enrolled in a high-deductible health insurance plan.
Since people with high-deductible health plans could face more out-of-pocket costs, due to the higher deductibles, the government provides tax incentives to motivate people to save for these expenses. HSA account holders can contribute pre-tax dollars to the account and can then withdraw money from the account, tax free, when paying for qualified medical expenses.
So how does a health savings account get the incredible honor of being named the ultimate retirement account?
Before answering that, let’s first briefly touch on some of the benefits of other types of retirement accounts.
These are the most common retirement accounts and are great for two reasons:
You eventually have to pay tax when you withdraw money but since you receive a tax break when you put money in and the money is able to grow tax free, it is usually worth maxing out these accounts to take advantage of these benefits.
A Roth IRA is different because you have to pay tax on your income up front, like you do with income that you spend, but the money grows tax free and you do not have to pay any tax when you withdraw the money after you reach the age of 59.5. So using the salary in the above example, if you contribute $5,000 to a Roth IRA, you will still initially pay tax on your full $100,000 salary but you don’t have to pay any tax when you withdraw the money.
For most of the population, an HSA is simply a savings account for medical expenses that provides some tax benefits.
For fientists, however, I suggest you disregard the medical aspect of the account and simply think of the account as a special retirement account that you are able to contribute to when you are enrolled in a high-deductible health plan.
When used intelligently, the HSA can potentially provide the best benefits of both a Traditional IRA and a Roth IRA combined. With an HSA, you are not only able to contribute pre-tax dollars, like you can with a 401k/403b/Traditional IRA, but you can still enjoy the tax-free growth and tax-free distributions that a Roth IRA provides!
That means you could potentially have tax-free contributions in, tax-free growth, and tax-free distributions out!
Well, this is all possible because of the fact that there is no rule stating that you must use your HSA to directly pay for medical expenses or that you must withdraw money from your HSA within a certain amount of time after paying for a medical expense. As long as the qualified medical expense occurred after the HSA was opened, you can withdraw money from the HSA at any time after incurring the expense to reimburse yourself.
Let’s assume that I only spend $200 a year on medical expenses. It doesn’t make sense to pay a lot of money for a fancy, full-service health insurance plan, since I rarely go to the doctor, so I instead decide to get a cheaper, high-deductible health plan with a lower monthly premium.
Since I have a high-deductible health plan, I am able to open a health savings account so I elect to put $3,000 into the account every year and I invest the account’s money in a total stock market index fund.
Because contributions to the HSA are pre-tax, depositing $3,000 into my HSA decreases my taxable earned income by $3,000.
When I go to the doctor, I can pay for my $200 yearly visit with my HSA debit card or I can pay for it with cash or with another credit or debit card instead. If I pay with my HSA debit card, that money is extracted directly from my HSA and that’s the end of the story. I just used tax-free dollars to pay for the expense and there is nothing else I can do.
If I instead pay with cash or with another card, however, I am able to withdraw that $200 from my HSA and deposit it into my normal checking account at a later time, to pay myself back for the qualified medical expense. The great benefit of having an HSA is that I can decide when to pay myself back. Since I live well below my means and have ample savings, a $200 payment isn’t going to break the bank so there is no rush to get paid back from my HSA. Instead, I am able to leave that $200 in my HSA and can sit back and watch it grow, tax-free, until I decide to withdraw it!
As long as I keep my receipts, I can withdraw the money for qualified medical expenses from my HSA at any time, in a similar way a retired person over age 59.5 can withdraw money from a Roth IRA…tax free!
So at the end of the year, I have saved myself from paying income tax on the $3,000 of income I used to fund the account, I now have $2,800 that is growing in the HSA tax free, and I have another $200 that is in the HSA growing tax free that I can withdraw whenever I want to!
I can hear you saying, well what if I put all this money into my HSA but I don’t have any health issues…how will I ever get my money out?
In this case, the account will simply act like a Traditional IRA with an increased distribution age (65 instead of 59.5 for a Traditional IRA). Like a Traditional IRA, your contributions to the HSA are pre-tax contributions and your contributions are allowed to grow tax free. If you don’t use your HSA funds for medical expenses, you can begin withdrawing money from your HSA account for any expenses after you turn 65, without penalty. Like a Traditional IRA, you’ll have to pay income tax on any distributions that aren’t for qualified medical expenses but you won’t incur any additional penalties or fees. Therefore, after the age of 65, an HSA is nearly identical to a Traditional IRA!
So to describe the above example in another way, the HSA at the end of the first year is like a Traditional IRA with a balance of $2,800 and a Roth IRA with a balance of $200. As I incur additional medical expenses, I can continue converting my “Traditional IRA” money to “Roth IRA” money without having to pay tax on the conversion!
The HSA is particularly useful for someone like me who maxes out all of the other tax-advantaged accounts available.
Since I’m in the wealth accumulation phase of my journey to financial independence, I try to limit my taxes as much as possible so that I can make as much of my money work for me as I can. The HSA allows me to contribute more of my income to tax-advantaged accounts, which results in a lower income tax burden and a higher savings rate.
If your annual medical costs are low and you don’t expect to reach your deductible in an average year, you can reap some amazing benefits by choosing to enroll in a high-deductible health plan. Not only will your monthly costs be lower, you’ll be able to take advantage of a health savings account and all the benefits that come with it.
Let me know in the comments if you have any questions and as always, I am not a medical or tax professional so please do your own research before making any changes to your health coverage or retirement investments.
What do you think? Do you agree that an HSA is the ultimate retirement account? If not, what type of account gets your vote?
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thanks for the article! I have one of these but never bothered to look at the details >_<
Glad it was helpful, Greg!
That’s great you already have an HSA set up so that you can start taking advantage of it immediately.
Let me know if any questions arise as you dive into the details.
Brillant post here, Mr. MF.
In fact, I liked it so much I added an addendum to my own Stocks Part VII post discussing IRA, 401K and the like with a link to it.
As I said there, RE HSAs, I couldn’t have said it better myself and so I didn’t!
You’re too kind, Jim!
As I said in our Mad Fientist FI Podcast interview, I honestly think your stock series is the only thing a person needs to read to become a successful investor so I am truly honored that you included a link to my article in that series!
I have a different take on this. I think they’re great for individuals who can take advantage of them, but we don’t meet the “low medical expenses” criteria so for me an HSA is useless. Worse, I suspect that if you analyzed the impact of many healthy people taking HSA’s on the cost of medical goods and services, there may be some nasty side effects from healthy people removing themselves from the insurance pool and instead diving into these HDHP / HSA arrangements. Perhaps choosing an HDHP / HSA should come with a higher bar of entry if your medical situation changes later and you need traditional health insurance. When you get down to it, this article basically describes a way to game the health insurance system to avoid taxes; no criticism of individuals who choose this is intended; I’d do it as well if I could. But using these plans as a back door to higher retirement asset levels seems like a distortion of the health insurance market that only benefits a few. If I could vote to eliminate them, I would.
Hi Mike, thanks for the comment. High Deductible Health Plans (HDHPs) definitely aren’t for everyone so I agree HSAs are useless for people who are better off with another type of insurance plan.
While HDHPs are usually best for people with low medical expenses, sometimes they can actually be a good option for people with very high medical expenses as well. My health care provider, for example, offers a HDHP that has maximum annual out-of-pocket expenses of $2,500 for individuals and $5,000 for families. The other two “full-service” health plan options, which have higher monthly costs and don’t provide access to a Health Savings Account, have much higher out-of-pocket maximums ($4,500/$5,000 for individuals and $13,500/$15,000 for families). So for someone who could potentially need expensive procedures or require extended hospitalization, it may make sense to enroll in a HDHP, in order to minimize annual out-of-pocket costs and be able to utilize the HSA tax benefits described in the article.
As far as gaming the health insurance system, I don’t really see it that way. The government is providing an incentive to save for health expenses and I’m taking advantage of that incentive. Over the long run, I will be less reliant on an already stressed system, because I will be able to pay for more of my own medical expenses, so I can’t imagine the government would be too concerned with me maxing out my HSA and letting it grow for years/decades until I need to use it.
I’m not sure I understand what you mean by “HDHP/HSA should come with a higher bar of entry…”. Would you mind explaining that part a bit more?
Hi Mad Fientist — I’m following you over from 20somethingfinance where I saw your comment there about HSA distributions using old medical receipts (the same as your article here discusses). I’m duplicating my comment on 20somethingfinance here to ensure you see it, plus it pertains to this article as well:
“No, you can’t do that.
Only “Qualified Medical Expenses” (QME) can be withdrawn from your HSA, and a QME is only valid in the YEAR the expense is PAID.
For example, if you go to the doctor in December 2012 — but pay the bill in January 2013, then that is a “Qualified Medical Expense” for tax-year 2013. You can’t, as you imply, pay that bill in 2013 out of pocket, and then get a distribution from your HSA in 2016 (or some future year).
This is mentioned in the language in IRS Pub 969 (talking about “Qualified Medical Expenses” for HSAs), and IRS Pub 502 defining when a “Qualified Medical Expenses” is good for:
“You can include only the medical and dental expenses you paid this year, regardless of when the services were provided.”
I erroneously thought the same as you a few years ago and a quick call to the IRS help line set me straight then: 1-800-829-1040″
Hi BG,
Thank you for getting in touch. I try very hard to ensure everything I post here is accurate so I’m really thankful that you took the time to speak up when you thought something I wrote was incorrect.
I had read the IRS Pub 969 when doing research for this article but I didn’t look at the IRS Pub 502 that you mentioned. I just looked through it now though and to me it still seems ambiguous. I can see how Pub 969 defines qualified medical expenses as “expenses that would generally qualify for the medical and dental expenses deduction”, as defined in Publication 502, and Pub 502 does say “You can include only the medical and dental expenses you paid this year” but to me, that doesn’t explicitly mean the HSA can only be used for current year expenses.
Publication 502 describes what medical and dental expenses you can deduct on your tax return so it makes sense that you can only deduct qualified medical expenses that were paid for in the tax year that you are hoping to receive the deduction. For HSA purposes, however, just because it doesn’t fall within the current tax year doesn’t mean it wasn’t a qualified medical expense. To take a deduction, Pub 502 states that the expense has to be a qualified medical expense AND has to have been paid for in the current tax year but an HSA distribution just states that it has to be a qualified medical expense, as defined in Pub 502. To me, the date the expense was paid for is additional information and does not determine if a medical expense is a qualified medical expense.
Saying all that though, if you actually spoke to the IRS about this, I definitely believe what you’re saying. I will give them a call to get clarification on everything and will update this article accordingly.
Thank you very much again for the comment and I will be in touch again soon.
When I called the IRS a few years back, it was for a real example I was facing. I had roughly $8k in QMEs, but only $6k (max contributions) in the HSA. My question to them was whether I could ‘roll’ the extra $2k in QMEs into the next year and take the distribution from the HSA then (when I could add an additional $6k to the HSA again).
The IRS agent pointed me to Pub 502 and said the best I could do in my current situation was try to delay the payments to the medical providers into the next year. Any payments I had already made in the current year would not count as a QME for HSA distributions in a future year.
If you call the IRS and find that they have changed their position on this, that would be very good news.
OK, I stand corrected. I called the IRS again, and spoke with a representative who put me on hold a few times to research the question. She changed her mind from originally “you can’t do that” to ultimately coming to the conclusion that yes, you can ‘roll’ your QMEs into the future and take the HSA distribution at any arbitrary future time (be that years away).
She did say, however, “unless my specific plan precludes that” — though it isn’t clear if that is my employer’s ins. plan, or the bank (HSA) trustee that could preclude us from using HSAs this way.
Regardless, as far as the IRS is concerned, there is nothing in the rules preventing us from saving QME receipts, and deferring HSA distributions indefinitely — as long as you had an HDHP insurance plan when the expense was incurred.
Also, though this is common sense: no ‘double-dipping’ allowed: using the same QME for multiple HSA distributions and/or using a QME that was deducted on Sched A in any tax year.
BG, that’s great news! Thanks a lot for giving the IRS another call.
Tax documents are such a pain to interpret so that’s a great idea calling the hotline to ask questions. I’ve never thought to do that in the past, I’ve always just suffered through hours of frustrating reading instead, but I can definitely see myself using that service in the future.
Thanks again for bringing your concerns to my attention and for following up. It’s nice to know there are people out there keeping me honest!
I realize I am late to this party, but I enjoyed the article and it has made me think more about fully funding my HSA account. I currently fund some but I do not max it out.
I wanted to point out another advantage of an HSA account with high deductible health plans. Many companies are encouraging HDHP and HSA’s by giving money HSA accounts. I’m assuming this is because it also saves them money. My company gives me $500 a year into my HSA.
So just another way to get “bonus” money from my company above and beyond my salary.
Welcome, Peter! It’s better to come late to a party than to not come at all so thanks for joining the discussion.
That’s amazing your company contributes $500 per year towards your HSA. I imagine that your free $500 combined with the amount you save on monthly premiums by having a HDHP adds up to almost cover the difference in deductibles between the HDHP and some of the other options. Your HSA is the super ultimate retirement account!
Great article! As a financial planner, just wanted to add one extra feature that gives the HSA an extra vote as the “ultimate” retirement account. If you contribute through payroll deduction, you also save on Social Security and Medicare tax (7.65% this year)! You do not receive this extra tax break if you do not contribute through your paycheck at work.
Thanks, Nick! That is definitely another incredible benefit and one that I actually didn’t even recognize. This is why I love writing about this stuff here…other smart people like you come to my house and tell me more interesting information about topics that interest me. The HSA keeps getting better!
Which HSA custodian do you recommend? Mine is currently at a local credit union since it’s free of fees and I have a small balance thus far.
Hi Nephi, I would recommend a custodian that a) doesn’t charge account fees and b) allows you to invest in low-cost index funds. Hopefully your local credit union has some good low-cost investment options so that you don’t have to worry about moving the money you already have invested and can instead just focus on maxing out the account every year!
Any custodians you would recommend I look at that offer both those? The current is no fees, but only basic interest accounts. (at most, .7%)
Ahh, I see. A basic interest-earning account really won’t let you maximize the HSA as I described in this article.
The first thing I would do if I were you is check to see if your employer offers an attractive HSA option. My employer offers a Fidelity HSA and they pay the annual fee so I’m able to invest in low-cost index funds without paying any fees. Going through my employer also means I don’t have to pay Social Security and Medicare tax on that money, as Nick mentioned in his comment above, since my HSA contributions are deducted directly from my paycheck.
If your employer doesn’t offer a good option, your best bet may be to go with Health Savings Administrators. They charge an annually fee but they allow you to invest in Vanguard Admiral shares, which are the best index funds you can invest in, in my opinion.
You could also take a look at HSA Bank. Their investment option is provided through TD Ameritrade, which offers quite a few commission-free ETFs, including several good Vanguard ETFs whose expense ratios are equivalent to Admiral shares.
Awesome post. I am maxed out on Roth and 401(k) and working toward financial security. This is perfect! I really appreciate the post!
Thanks, David! Thanks a lot for stopping by!