Health Savings Accounts (HSAs)
I have spent many hours discussing the relative advantages and disadvantages of Roth 401(k)s versus Traditional 401(k)s. The answer in that debate? It depends … but what if you could have the best of both?
While Roth plans generally give you tax-free distributions, you pay taxes prior to contributing dollars to the plan. Conversely, Traditional plans allow your contributions to avoid current taxation, however you pay taxes on your distributions.
So the IRS gets you on the way in or on the way out. However …
HSAs generally allow you to take a tax deduction on your contribution (like the Traditional) and gives you tax free distributions (like the Roth). The best of both worlds!
To enjoy the tax free distributions noted above, HSAs can only be used for qualified healthcare expenses. So they shouldn’t serve as your main retirement vehicle. Yet many experts estimate there will be plenty of healthcare expenses in retirement. One could argue this isn’t much of a limitation.
The main limitations relate to eligibility and contributions. To contribute to an HSA, your health insurance plan must be a High Deductible Health Plan (HDHP).
For 2019 the IRS defines a HDHP as any plan with a deductible of at least $1,350 for an individual or $2,700 for a family. A HDHP’s total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) can’t be more than $6,750 for an individual or $13,500 for a family. More nitty gritty from the IRS can be found here.
Unlike Flex Spending Accounts, HSAs allow you to roll the cash balance over year to year, however you can use HSA funds in the year of contribution or any year thereafter. And over time hopefully your medical expenses don’t exceed your contributions. As your cash balance grows HSAs provide mutual fund menus (varying by provider) that allow the account holder to invest cash balances into longer term investments.
Combined with their uniquely favorable tax treatment the flexibility to use the balances in the short or long term make HSAs a uniquely powerful financial tool.
A large and growing number of companies offer HDHPs as an option during open enrollment, and they are typically available through health plan marketplaces. So, there is a good chance an HSA eligible plan is an option for you. However, individuals or families with significant medical expenses may want to select lower deductible alternatives, at least for the years where expenses are expected to be high. The higher out-of-pocket expenses may outweigh the tax benefit.
Generally healthy individuals and families with adequate cash reserves and low current expected medical expenses are great candidates to take advantage of HSAs.