Millions of Americans are eligible to contribute to health savings accounts, or HSAs, but few people actually take full advantage of this tax-advantaged investment account or realize the full extent of its benefits. Here's what you need to know about HSAs in 2018, and why their unique benefits make them one of the best tax-advantaged account types of all.

What is a HSA?

A HSA is a tax-advantaged account designed to allow people with certain types of health insurance plans to save for medical expenses.

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One of the biggest differences between a HSA and the more widely known flexible spending account, or FSA, is that you don't need to spend all of the money in your account each year, or any of it at all. You are allowed to carry over any unused balance year after year.

Another difference is that because it's a more long-term focused account, money in your HSA can be invested until you're ready to use it. This is generally structured similarly to a 401(k), with a basket of investment funds you can choose from. Since they are similar to 401(k)s, the guidelines for picking 401(k) investment funds apply. For this reason, HSAs can make excellent retirement savings vehicles, but we'll get into that later.

2018 qualifications and contribution limits

One of the worst characteristics of HSAs is that they aren't available to all Americans. In order to be eligible to contribute to a HSA of your own, you need to have a qualifying high-deductible health plan.

The IRS definition of a "high-deductible" health plan changes over time, but for 2018, it is defined as a policy with a deductible of at least $1,350 per individual or $2,700 for a family, and whose out-of-pocket maximum is at most $6,650 or $13,300 (individual/family).

It's also worth pointing out that if you're covered by a high-deductible plan and another non-qualifying health plan, you can't use the high-deductible plan as grounds for eligibility. Medicare recipients as well as anyone who can be claimed as someone else's dependent don't qualify either.

If you qualify, you can contribute as much as $3,450 to a HSA in 2018 if you have individual health coverage, or $6,850 if you have a family health plan. And if you're 55 or older, you can contribute an additional $1,000 as a catch-up contribution. You can make your HSA contributions for a given tax year until the April tax deadline for that year. For example, your 2017 HSA contributions can be made until April 17, 2018.

In addition, if your HSA is provided through your employer, then your employer may make contributions on your behalf, which don't count toward your annual limit.

A triple tax benefit

One of the more notable features of the HSA is that it's one of the few tax-advantaged accounts in existence with a triple tax benefit. First, money that you put into a HSA is contributed on a pre-tax basis, meaning your contributions are tax-deductible. Second, as long as the money is used for qualified healthcare expenses, your withdrawals -- including any investment gains -- are 100% tax free. And finally, while your money is invested in the HSA, any interest, dividends, or capital gains you earn aren't taxed.

What's more, after you reach age 65, you can withdraw money from the account for any reason without paying a penalty, although the money you withdraw for non-medical expenses will be considered taxable income, as it would in a traditional IRA or pre-tax 401(k).

However, it's important to mention that if you withdraw any money from your HSA before age 65 for any reason other than paying medical expenses, you'll face a 20% penalty from the IRS.

Here's just one possible example of how this can help you. Let's say you have a qualifying high-deductible family health plan and decide to contribute the 2018 maximum contribution of $6,850. If you're in the 22% tax bracket, you can reduce your 2018 tax bill by $1,507. If you're 40 now and leave the money alone until you're 65, it could grow to more than $37,000 based on annualized 7% returns, and you'd then be free to use this entire amount tax-free for healthcare costs, or withdraw it to supplement your retirement income.

And this example assumes you contribute for just one year. As you can probably imagine, maxing out your HSA contributions every year can grow to a pretty large nest egg over time.

What expenses qualify?

There's a long list of expenses that can qualify for using HSA funds, and the IRS-defined "medical expenses" are listed in IRS Publication 502, but just to name a few:

  • Chiropractor services.
  • Dental services.
  • Diagnostic devices.
  • Surgical expenses.
  • Fertility treatments.
  • Hearing aids.
  • Home care costs.
  • Laboratory tests.
  • Long-term care costs.
  • Prescription medications.
  • Nursing services.
  • Psychiatric care.
  • Eye exams, glasses, and contact lenses.
  • Medical devices such as crutches.

If you're curious about an expense, IRS Publication 502 also includes a list of expenses that are specifically not considered to be medical expenses.

A great tool for retirement planning

You can probably see why a HSA can be just as useful as an IRA to save for retirement, and in many ways, it's better. Just to recap a few of the retirement-saving advantages of a HSA:

  • You get a current-year tax deduction for your contributions.
  • In addition, money withdrawn for medical expenses is tax-free, effectively combining a benefit of Roth IRA investing with the immediate tax savings of a traditional IRA.
  • If you have a high-deductible family health plan, the $6,850 contribution limit is more than the $5,500 an IRA allows, although you can choose to contribute to both, if you meet the qualifications for each one.
  • Unlike traditional IRAs, there are no required minimum distributions with a HSA after you reach age 70 1/2.
  • The only main qualification is a high-deductible health plan. There are no maximum income thresholds that can disqualify you from a HSA, as exist with traditional and Roth IRAs.

According to Fidelity, the average 65-year-old couple can expect to spend $275,000 throughout their retirement on healthcare expenses. And keep in mind that if you're still years away from retirement, inflation is likely to drive these costs much higher.

Not only can a HSA allow you to set money aside for current-year medical costs, but it can also let you invest for your future healthcare expenses while saving money on your tax bills, both now and in the future.

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