Health savings accounts (HSAs) are a type of tax-advantaged investment account available only to individuals with a high deductible health plan (HDHP). If you're eligible to contribute to an HSA, there are ample reasons to do so, as these accounts offer benefits including generous tax savings and flexibility in how and when funds are invested and spent.
HSAs allow your money to grow until retirement, when you're more likely to experience substantial medical expenses. Recent estimates from Fidelity indicate a senior couple turning 65 in 2020 with high prescription drug needs will need $325,000 to have a 90% chance of covering Medicare premiums, medication, and other out-of-pocket medical expenses throughout retirement. HSA funds can help ensure retirees are prepared for these expenses.
However, despite the benefits of HSAs, there are also a few disadvantages, including strict limitations on who can contribute and substantial penalties on withdrawals for nonhealthcare expenses before age 65.
To help you decide if contributing to an HSA is right for you, here are eight major HSA benefits, as well as four downsides worth thinking about.
Eight health savings account benefits
The major HSA benefits include the following:
- HSAs are triple tax-free: Contributions to an HSA are made with pre-tax dollars, invested funds grow tax-free, and you aren't taxed on withdrawals as long as the money is used for qualifying medical purposes. Other tax-advantaged savings accounts require you to choose between contributing with pre-tax funds and making tax-free withdrawals.
- There are no income limits on HSA contributions: Some high earners cannot contribute to a Roth IRA or make deductible contributions to a traditional IRA, but HSAs don't impose income limits.
- HSA funds can be withdrawn anytime to cover qualifying medical expenses: While HSAs make an excellent retirement savings vehicle, they're intended to help defray the costs of medical care so you can take money out anytime to pay for qualifying medical services.
- HSAs aren't use-it-or-lose-it: Unlike with flexible spending accounts (FSAs), you don't have to use the money invested in an HSA in the year you contributed it. There's no timeline for when you must withdraw your funds.
- Seniors 65 and over can withdraw money penalty-free for any purpose: Withdrawals not used for covered medical services are subject to a 20% penalty, but not for those over 65. Seniors can take money out for any reason and simply pay ordinary income taxes. This flexibility helps make HSAs ideal for retirement savings.
- There are no required minimum distributions (RMDs): Most tax-advantaged retirement accounts, including 401(k)s and traditional IRAs, are subject to RMDs, which mandate a certain withdrawal every year. Those who are 72 or older must take RMDs annually or be subject to a 50% penalty on the amount not withdrawn. With HSAs you can leave your money invested as long as you'd like.
- You have flexibility in where you open an HSA and what you invest in: Your employer may offer an HSA, but you can also open one on your own with your choice of bank or brokerage firm if you're eligible. You'll have access to a wide pool of investments and can generally buy any stocks, bonds, or other assets your brokerage offers.
- Employers may make HSA contributions for some workers: If you're investing in an HSA offered through work, your employer may contribute money for you.
HSA tax benefits
The tax advantages are worth reiterating, as they're the single biggest HSA benefit.
When you invest with pre-tax dollars, your contributions don't reduce take-home pay as much. If you make a $1,000 deposit, it would effectively reduce your take-home pay by only around $780, assuming you are in the 22% tax bracket, and save you $220 on taxes.
Several accounts, including traditional 401(k) and IRAs, offer this type of savings. But unlike these other accounts, you also aren't taxed on HSA withdrawals used for qualifying medical expenses. While a $1,000 401(k) distribution would give you around $780 in spending power after taxes (again, assuming you're taxed at 22%), a $1,000 HSA distribution would give you $1,000 to pay for medical care.
You can also make HSA contributions without affecting eligibility for other types of tax-advantaged accounts, such as 401(k) and IRAs, so they simply provide an additional tax-advantaged option to save for your future.
However, there are some disadvantages to an HSA:
- You must have a high-deductible health plan to contribute.
- You're subject to a 20% penalty for withdrawals made before age 65 if you don't use the money for medical purposes.
- You may be charged fees for an HSA account.
- HSAs have lower annual contribution limits than some other tax-advantaged accounts.
For many people, the advantages substantially outweigh the downsides, especially as you can contribute to an HSA without affecting eligibility for other tax-advantaged accounts. However, for those who don't have a HDHP and who aren't eligible, this downside is the only one that matters, since they won't have the option to use an HSA and reap its benefits.