With the increase in high deductible health plans (HDHP) being offered by employers, it is surprising to find how few individuals take advantage of a Health Savings Account (HSA). Not only can these plans offer a way for individuals and families to save for current medical expenses in a tax-efficient manner, because of their unique structure and features, HSAs are a perfect vehicle to save for retirement and other financial needs.

HSA Basics

In order to contribute to an HSA, you must first be enrolled in a high deductible health plan. For 2022, you can contribute $3,650 for individual coverage, up from $3,600 for 2021, or $7,300 for families, up from $7,200. If you are 55 and older, you can make an additional $1,000 catch-up contribution. 

One of the greatest benefits of an HSA is the triple tax advantage – contributions are made pre-tax, earnings are tax-free, and as long as you use the funds for a qualified medical expense, the withdrawals are also tax-free. If you directly contribute to an employer-sponsored HSA through payroll deduction, you also benefit by not paying FICA (Social Security and Medicare) taxes on the contribution, which saves another 7.65%.

Funds held within an HSA can be used to pay for a wide array of medical expenses for yourself, your spouse, or dependents. If for some reason you need to withdraw funds from an HSA for non-qualified expenses before you turn 65, you will owe income taxes on the money plus a 20% penalty. After age 65, any non-qualified withdrawals will be taxable, but penalty-free.

Flexibility of an HSA

Despite the potential income taxes and penalties associated with using the funds for non-qualified expenses, the triple tax advantage discussed above and the flexibility of an HAS, more than make up for it.

Although contributions to an HSA are commonly used to pay for current medical expenses, they offer the most benefit for individuals who hold the funds long-term for future expenses. Unlike a Health Care Flexible Spending Account (FSA), contributions to an HSA do not have to be used up each year. According to the Fidelity Retiree Health Care Cost Estimate, “an average retired couple age 65 in 2021 may need approximately $300,000 saved (after tax) to cover health care expenses in retirement.” Being able to sock away tax-advantaged funds to be used in retirement can help cover a portion of the high health care costs you may face as a retiree.

If you plan to use your HSA account(s) for long-term purposes, I recommend investing the contributions in low-cost index funds to maximize the benefits of the tax deferred account status and take advantage of compounding. Many employer-based HSAs have very limited or no investment options, but you can transfer the funds from your employer-sponsored HSA to a personal HSA that allows for more investment alternatives. An unlimited number of these custodian-to-custodian transfers are allowed, though do take into consideration any fees associated with the transfer. If the transfer fees are high, moving the funds from your employer to a personal HSA once a year could be the most economical strategy.

Unlike most retirement plans, HSA’s have no required minimum distribution. This gives the account holder more control over when the funds are disbursed and greater latitude for tax-efficient income planning in retirement.

For those who still doubt the power of the HSA, with an HSA you can be reimbursed for past qualified-medical expenses with no limitations on how long ago it happened, if your HSA was established prior to when the expense was incurred. For example, with current HSA rules, you can have a $1,000 medical expense that you don’t get reimbursed for immediately, 5 years later you can be reimbursed for that $1,000 with no income tax or penalties as long as you have documentation showing the qualified expense (such as a bill and receipt) and proof that it occurred after establishing an HSA. This takes some exceptional organizational skills but is an option for those concerned with locking their funds in an HSA account.

Should you take advantage of an HSA?

HSAs have a multitude of benefits, but they aren’t for everyone. Because you must be on a high deductible health plan to contribute to an HSA, one of the biggest factors to consider is your and your family’s health and whether being on a high deductible health plan makes sense. If you have a chronic health condition, high-cost medications, or need to visit healthcare providers on a very regular basis, a high deductible health plan may not be the best option for you. High deductible health plans are also not a great choice for individuals and families who know with fairly high certainty that in the coming year they will have higher than normal healthcare costs due to a planned surgery or the birth of a child.

High deductible health plans are also not a good solution for individuals who do not have the means to pay the high deductible if they were to face large medical bills. For these situations it makes more sense to choose a PPO plan with a higher premium, but lower deductibles.

Finally, I suggest making sure you have some form of emergency savings in place prior to putting funds into an HSA. The advantages are many, but if you must dip into your HSA for nonqualified expenses, the 20% penalty negates the benefit of the account. You should also ensure you are taking advantage of any employer retirement match—particularly if you are vested at 100%–before adding funds to an HSA. These matches could offer anywhere from a guaranteed 50 to 100% return depending on the level of match received. Contribute enough to your employer retirement plan to get the match and then look at funding an HSA.