By In Do the Math, Health Financial Accounts, Health Savings Accounts (HSAs), High-Deductible Health Plan (HDHP)

Why We Talk So Much About HSAs for FI

Confession: It took me a long time to come around to liking HSAs. The analyst in me looked at “consumer-driven health plans” (CDHPs) as not consumer-driven at all but rather a way for employers to get us employees to pay more when we get sick. To be honest, I still feel that way. High-deductible health plans (HDHPs), which is the plan type you must have in order to qualify for a health savings account (HSA), are a hedge that allows employers to shift some of the ever-growing expense of providing insurance to the employees for which they’re providing it. They’re not ideal if you have a family or are thinking of starting one, you have a chronic condition you must manage, if you’re low-income and have an accident — basically anything that requires you to see a doctor or get a prescription or other medical products/services.

But there are caveats that make them pretty ideal if you’re on the FI journey.

The Triple Tax Advantage of HSAs Really Is an Advantage

The primary reason an HSA is an essential component of your FI saving strategy is that it’s a rare “triple-threat” of tax advantage.

  1. You are not taxed if/when when it is deducted from your paycheck. Like your 401(k) contribution, the money can be withdrawn from payroll pre-tax — so your contribution goes 10-25 percent further than if you set up your own savings account for medical expenses. Likewise, if you want to contribute money to your HSA outside of payroll deduction, you can do so (up to the annual limits) and then claim a deduction when filing your income tax returns for the year.
  2. You are not taxed if/when you use your HSA funds to pay for medical expenses. Example: when my wife gave birth to our daughter, we paid for the medical expenses with our HSA funds, which meant that that 10-25-percent boost for using pre-tax dollars made our overall expenses net out to less cost for us. (Plus, we met our annual deductible, which meant that the plan’s 100-percent payment after deductible clause kicked in, saving us money compared to the PPO my company offered).
  3. You are not taxed when withdrawing your HSA funds to pay for medical expenses after reaching retirement. So, to recap, that means that, provided you never use the money for anything but medical expenses, your dollars will never, ever be sliced by taxes. Plus, if you get to retirement and want to withdraw the funds for something other than medical expenses, you can do so and have your tax liability figured in the same way that your 401(k) is figured — the major difference being you don’t have to start withdrawing by age 70.5. In other words, your HSA can be treated as income and, if you’re claiming far less income in retirement than while you were working full-time, then your tax bracket will be lower and your taxes applied after making HSA withdrawals will be lower as well

That’s why you hear people talk so much about HSAs for retirement planning — it’s basically both a backstop on your medical expenses if and when you have a need to use them, and if you’re one of the lucky few who never has to visit a doctor or take a prescribed pill, you have all this extra money to play with in retirement.

How to Make the Most of Your HSA

Now that you know the value you can get from having an HSA, here’s a simple tip for making the most of it: treat it like you do your 401(k) and invest as much as you can.

  1. Max it out. Current contribution limits on HSAs are $3,450 for an individual and $6,850 for a family. Max that puppy out if you can, because the more you put into the account, the more value you’ll get out of it. There might be a small tinge of “But now I’m paying a lot more for my health insurance,” but in reality you’re making your dollars go even further toward your FIRE goals.
  2. Invest it. Sometimes, depending on the service your employer or insurer uses to manage your HSA, it can be hard to figure out how to invest your HSA funds. But ask your HR/benefits manager for details and, if they can’t help you, ask then to connect you with someone who can. It’s your money, not the company’s, but they are offering it to you and should help you out. You absolutely want to invest it, and most companies will help you do so with the same options, like indexed funds or mutual funds at different risk-tolerance levels, as you would get in a retirement savings account.
  3. Sit back and do nothing. As Harold Pollack and countless others suggest, the best thing to do with your retirement savings is nothing. HSAs, unlike flexible spending accounts (FSAs), are not “use it or lose it,” meaning your funds can roll over from year to year and get as large as your investment strategy can get them. Just let it grow and grow and grow until you have met your goals and are ready for early retirement!

Should you use Your HSA for Medical Expenses?

This is a question we will cover in more detail in another post, but the short answer is probably not. I did note above that we used our HSA funds to pay for medical expenses when our daughter was born. It was a solid arrangement that saved us money. But if you’re on a 15+ year retire-early savings plan, which would assume that you have the financial means to pay for a substantial medical event like childbirth out-of-pocket, then math would tell you to do it.

Here’s the quick math: Let’s say your medical expenses are $20,000 for having a child, including all doctor visits prior to giving birth, through delivery and through one year of baby well-visits. Of this amount, your annual deductible of $5,000 means you are responsible for half, $10,000, of the expense and your insurance pays the rest. (Reality wouldn’t be in these tidy round numbers, but the basic math is close.) By paying with your pre-tax HSA funds, your “real cost” is about $8,000-8,500 — you’ve saved about $1,500-2,000.

Now, if you paid out of your own pocket (i.e. did not use the money in your HSA) for your expenses, all of the costs would be roughly the same — still on the hook for $10,000 in expense due to your deductible, but insurance still picks up the post-deduction balance — and your additional cost would be the $1,500-2,000 you saved on taxes. But on the flip side, if you took the investment value of that $10,000 you spent, at an annual earnings rate of 5 percent, you are looking at total earnings over 15 years of $10,790. Subtract $2,000 and you gross $8,790 in added costs.

Even if you do the math on forgoing that savings for the two years that you spent the money, you are still within $500-1,000 of the tax cost to you, and you lose the additional compound value over the number of years on your savings plan to retirement.

This accounting assumes your ability to pay that significant of a medical expense, which may not be the case. If so,the combination of HDHP reducing your costs on major medical expenses and the investment potential of the HSA with your HDHP, could leave you with good options for your present and your future.

Much more to come!

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