Unless you are extremely wealthy, there aren’t many tax shelters available to you and healthcare costs are likely a rising concern. For both of those reasons, I am a big fan of Health Savings Accounts (HSAs). The HSA is one of the few avenues available to shelter income from tax and they provide a great way to set aside a reserve for future medical expenses.

health savings

In order to be eligible to contribute to a Health Savings Account, you have to be covered by a High Deductible Healthcare Policy (HDHP). As the name indicates, the deductible on these policies is higher than normal. If it is likely that you’ll hit the deductible or if the healthcare plan is not suitable for you for some other reason, look for a non-HDHP policy that is a better fit and forgo the HSA.

Assuming you can find an HDHP policy that meets your needs, you’ll need to open a separate HSA account. There are a number of providers for Health Savings Accounts, and this New York Times article provides a ranking of providers. Once your coverage under the High Deductible policy begins, you can begin making contributions to your HSA, up to a maximum of $3450 for individuals and $6900 for families. Contributions to an HSA reduce your taxable income, much like contributions to a traditional 401k, so if you’re in a high tax bracket it can lower your income taxes by a few thousand dollars.

Once the funds are in the HSA account, unlike older Flexible Spending Accounts, you do not have to spend the funds in a given year. What you don’t use simply accrues, and furthermore, you can invest the HSA funds just as you can with other types of accounts like IRAs and brokerage accounts. There are a couple of things to bear in mind if you elect to do this, as follows:

  • Make sure your HSA account provider offers the option of a linked brokerage account.
  • Unless you have a sufficient reserve outside the HSA to cover medical expenses, you’ll want to keep some of your HSA funds in cash.
  • Check into the fees for making trades in the linked brokerage account and see if the brokerage firm will waive fees if you sign up for a periodic purchase plan. If trading fees make up more than a percent or so of the overall purchase price, plan on making fewer trades for larger amounts.

The growth of funds in Health Savings Accounts isn’t taxed, and if you use the HSA funds for qualified expenses, withdrawals aren’t taxed either. Qualified expenses are fairly broad, and the IRS defines them as those medical and dental expenses that would qualify for the medical and dental expenses deduction which they cover in Publication 502. Additionally, HSA funds can also be used to cover insurance premiums including long-term care insurance premiums up to certain limits, COBRA coverage or insurance coverage while you’re unemployed and Medicare premiums. HSA funds can’t be used for non-prescription medications aside from insulin or Medigap premiums.

If you use HSA funds for anything other than qualified expenses, the HSA withdrawal will be taxable at your current tax rate, and the IRS will tack on an additional 20% penalty if you are under age 65. However, given the breadth of what is considered a qualified expense — from medical and dental expenses to insurance premiums — it seems unlikely that you’d run short of costs to cover with an HSA, particularly in retirement. In fact an HSA can be a great vehicle to augment your retirement savings assuming you can afford to make ongoing contributions, invest those contributions and leave them in the account to accrue over time.

Minerva Planning Group is a fee-only financial advisory firm based just outside Atlanta in Decatur. You can contact them here.