3 ways to make your HSA work harder for you

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In a Nutshell

If you have a high-deductible health insurance plan, you may be eligible to contribute to a health savings account. HSAs are a tax-free way to save for — and pay for — healthcare. But you can also use them to invest and grow your money tax-free. Here are health savings account rules to know to help make your HSA work harder for you.
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This article was fact-checked by our editors and Christina Taylor, MBA, senior manager of tax operations for Credit Karma. It has been updated for the 2020 and 2021 tax years.

Good health is beyond price, but maintaining it can be expensive.

Of course, health insurance helps. But health insurance typically doesn’t cover every single cost associated with maintaining your health. For example, you may have insurance that pays for an eye exam but not for eyeglasses, contact lenses or saline solution.

When you have health-related expenses that insurance doesn’t pay for, you may be able to cover those costs through a health savings account if you qualify to have one. Let’s look at how you can establish an HSA, the basics of health savings account rules, and some ways you can make an HSA work harder for you this year.

HSA basics

A health savings account is a tax-exempt account you can set up with an HSA trustee, provided you’re eligible to have one. You can use the money in an HSA to pay for qualified medical expenses.

You could be eligible to contribute to an HSA if you’re covered by a health insurance plan classified as a high deductible health plan (HDHP). You can’t be enrolled in Medicare, can’t be claimed as a dependent on anyone’s tax return, and generally can’t have insurance besides your HDHP (but there are some exceptions, such as a policy covering only a specific disease). Your employer may offer you an HSA, or you can open an HSA on your own as long as you qualify for one.

Most health insurance plans have some type of deductible — an amount you must pay for covered healthcare costs before the insurance begins to pay. HDHPs generally have a higher annual deductible than typical plans, and a maximum amount for the total of the deductible and out-of-pocket expenses (like co-payments) that you must pay for covered expenses in a year.

For 2020, an insurance plan can be considered a high-deductible plan if the minimum annual deductible is $1,400 for self-only coverage or $2,800 for family coverage. Also, the maximum annual out-of-pocket expenses cannot be more than $6,900 for self-only coverage or $13,800 for family coverage in 2020. For 2021, minimum annual deductibles are the same as 2020, but out-of-pocket expenses limits increase slightly to $7,000 for self-only coverage and $14,000 for family coverage.


What medical expenses can you pay with an HSA?

Generally, you can use an HSA to pay for the same types of expenses that would be included in a medical and dental expense deduction (if you qualified to take one). These can include but aren’t limited to:

• Over-the-counter drugs your doctor prescribes for you

• Birth control pills

• Medical supplies such as bandages

• Dental visits and treatment

• Inpatient treatment for drug addiction

• Eye care such as exams, glasses and contact lenses (needed for medical reasons)

• The costs of buying, training and caring for guide dogs or other service animals that help people with vision, hearing or other physical disabilities

• Lab fees

• Special education for children with learning disabilities (with a doctor’s recommendation)

For a more comprehensive list, check out IRS Publication 502.

If you meet the qualifying requirements for an HSA, you can contribute up to $3,550 for self-only plans and $7,100 for family plans in 2020. In 2021, the contribution limits rise to $3,600 for self-only coverage and $7,200 for family coverage. If you’ll be 55 or older at the end of either tax year, you may be able to make a catch-up contribution of an additional $1,000 to your HSA. Your employer may offer an HSA as an employment benefit and may contribute for you, in which case the total amount of your contributions and your employer’s can’t exceed the contribution limit.

Health savings accounts are fairly common. In 2016, close to three in 10 employees had a health savings account, and an estimated 20.2 million to 22.6 million insured policyholders and their dependents were enrolled in HSAs, according to the Employee Benefit Research Institute (ERBI).

The big tax advantages of HSAs

HSAs can offer significant tax advantages.

“Health savings accounts are treated in a tax favorable light by the IRS,” says Daniel Patterson, a certified financial planner with Sweetgrass Financial Planning in Mount Pleasant, South Carolina.

They are a “tax trifecta” because you can deduct the contributions you make (and don’t have to report employer contributions as income), any interest or other earnings the HSA gains aren’t taxed, and withdrawals may be tax free as long as they’re made for qualified medical expenses.

Plus, the money in your HSA remains yours even if you switch jobs or stop working.

Making your HSA work harder

If you’re wondering how to use your HSA to reap the maximum benefit from it, here are three basic tactics to consider:

  • Maximizing your tax deduction
  • Optimizing withdrawals
  • Maximizing tax-free growth

Let’s look at ways to execute each tactic.

1. Maximize your tax deduction

In 2016, only 13% of people who had HSAs contributed the full amount they were permitted to contribute for the year, according to EBRI. If you’re not contributing the full amount, you’re not making the most of your HSA — one of the most generous types of tax breaks available.

Other tax-advantaged accounts, such as 401(k)s, offer less generous tax advantages. While traditional 401(k)s allow contributions with pre-tax funds, withdrawals are taxed. With Roth IRAs, the opposite is true; you contribute after-tax dollars but get tax-free growth and withdrawals.

With HSAs, you can claim an income tax deduction on money going in and you won’t pay taxes on money coming out (provided withdrawals are for qualified medical expenses). That’s why Patterson describes HSAs as “one of the most tax-preferred vehicles around.”

Making the maximum allowed contribution gives you the highest possible deduction and allows more of your money to grow tax-free for future qualified use.

2. Optimize withdrawals

Three-fourths of HSAs that received contributions in 2016 also had distributions taken out that year. The average distribution amount was $1,766, according to ERBI.

Just because you can use your HSA dollars to pay for everyday healthcare expenses doesn’t necessarily mean you should. Remember, health savings account rules mean the longer your money stays in the HSA, the more interest and earnings it can gain — and grow toward helping you pay for bigger medical expenses when they occur.

“Even though the HSA is meant to help those in high-deductible plans pay for medical expenses, I’d suggest paying your deductible out of pocket, if possible, so that you can allow your HSA account to continue to grow,” Patterson says. HSA balances roll over from year to year if funds aren’t used, so this tax-advantaged account can continue getting bigger.

“To the extent possible, the HSA should be treated as a longer term or retirement account for medical expenses later in life,” says Josh Trubow, a certified financial planner and financial advisor with Sensible Financial Planning in Waltham, Massachusetts. “If you have other funds in a savings or checking account that are available, it may make sense to leave the HSA alone to accumulate tax free for use later.”

Healthcare costs can escalate in retirement. According to ERBI research, in 2017 a senior couple who retire by age 65 and whose drug costs are in the 90th percentile throughout retirement would need savings of $368,000 to have a 90% chance of being able to cover healthcare expenses in retirement. Money in an HSA can help bolster retirement savings.

Health savings account rules allow seniors older than 65 to make withdrawals from an HSA without penalty, even if funds aren’t used for qualified medical expenses.

If you do need to use your HSA regularly for healthcare-related expenses, be sure you understand what’s a qualifying medical expense and what isn’t. If you accidentally use your HSA to pay for medical expenses that aren’t qualified, you’ll have to pay tax on the distribution amount. You may also be subject to an additional 20% tax on the distribution.

3. Maximize tax-free growth

In 2016, just 3% of HSAs had any money invested in assets other than cash, data from ERBI shows. This could be a missed opportunity if your HSA is the type that allows you to invest through your HSA.

If you can, Patterson suggests “invest[ing] your HSA like you would your 401(k) or IRA, and think of it as a long-term asset,” Patterson says. He advises developing a diversified portfolio appropriate for your life stage and risk tolerance.

“Investing some or all of the funds can help grow the account more than leaving the money in cash could,” Trubow agrees.

Trubow suggests investing as long as you don’t plan to withdraw the money within the next year. “Investing the savings introduces risk to your account but gives you the potential for more upside.”

ERBI data from 2016 also indicates those who invested their HSAs in assets other than cash had much higher account balances than those who did not invest. This was true even though investors were more likely than non-investors to take distributions in 2016, along with generally taking larger distributions.

Bottom line

If you participate in a qualified high-deductible health plan, an HSA can be an effective way to pay for medical costs not covered by insurance. It’s important to know health savings account rules and how HSAs work. HSAs offer tax benefits through tax-deductible contributions and tax-free growth and eligible distributions.

Finally, leaving your money in an HSA for as long as possible and investing your HSA funds wisely can help grow your money and save for retirement. In retirement, your income will likely be less and your health expenses greater, so that tax-advantaged HSA money can be even more valuable.

Christina Taylor is senior manager of tax operations for Credit Karma. She has more than a dozen years of experience in tax, accounting and business operations. Christina founded her own accounting consultancy and managed it for more than six years. She co-developed an online DIY tax-preparation product, serving as chief operating officer for seven years. She is the current treasurer of the National Association of Computerized Tax Processors and holds a bachelor’s in business administration/accounting from Baker College and an MBA from Meredith College. You can find her on LinkedIn.

About the author: Christy Rakoczy Bieber is a full-time personal finance and legal writer. She is a graduate of UCLA School of Law and the University of Rochester. Christy was previously a college teacher with experience writing textbo… Read more.