How an HSA can be viewed as a flexible tax-favored investment.

AuthorGramlich, Jeffrey
PositionHealth savings account

This article shows how clients can benefit from viewing a health savings account (HSA) as a flexible tax-favored investment strategy. HSAs allow taxpayers of any income level to deduct contributions immediately and withdraw the contributions, with accumulated investment earnings, free of tax at any age. That is, the "health" moniker can be a misnomer by disguising a key benefit of an HSA: An HSA can be a flexible tax-favored investment vehicle.

Compared with more aptly named individual retirement accounts (IRAs), an HSA savings strategy (1) allows tax-deductible contributions like a traditional IRA but without its limitations on working alongside a Sec. 401(k); (2) allows tax-free withdrawals like a Roth IRA and without its income-based contribution limits; and (3) avoids waiting until retirement age for penalty-free withdrawals of earnings, as required by both traditional and Roth IRAs. This short article explains that U.S. tax law currently permits this tax-favored investment strategy by effectively combining the tax benefits of an HSA with an investment strategy. (1)

Sec. 223 allows a taxpayer covered by a qualified family high-deductible health plan (HDHP) to make deductible contributions to an HSA trust account of up to $7,300 in 2022 or $7,200 in 2021 (for taxpayers with a qualified self-only HDHP, $3,650 in 2022 and $3,600 in 2021). An additional $1,000 deduction is allowed for taxpayers who are at least 55 years old at any time during the tax year. Employer contributions made to an HSA are excludable from the employee's gross income (Secs. 106(d) and 125). The employer contributions to the HSA also reduce the annual limits on the employee's deductible contributions. An HSA remains with a taxpayer after he or she leaves an employer or the workforce entirely, which adds portability to the benefits of an HSA.

Withdrawals from an HSA to cover the costs of qualified medical expenses as defined in Sec. 223(d)(2) are tax-free, including withdrawals of investment earnings on the HSA funds. Employees can direct the HSA administrator to pay for qualified medical expenses directly from the account. Indeed, some plans provide HSA participants with debit cards to pay these expenses directly, which can help the taxpayer meet the substantiation requirements. Regardless of how medical costs are withdrawn, the taxpayer is responsible for documenting that the funds are used exclusively to pay for qualified medical expenses, that the expense has not previously been reimbursed or paid for by another source, and that the medical expense is not also included among itemized deductions.

An alternate approach--the strategy recommended here--is for the taxpayer to pay the medical bills personally and request reimbursement of these costs from the HSA only when he or she needs the funds. Of course, a taxpayer should carefully document each medical expenditure and carefully preserve this documentation. However, there is no time requirement for requesting reimbursement from the HSA. Therefore, a valid tax strategy is to pay medical costs from non-HSA funds, retain the reimbursement documentation, and wait until the funds are needed to obtain reimbursement for the costs. Note, however, this strategy is only useful to the extent that the taxpayer can afford to pay the medical expenses from sources outside the HSA. This approach is valid because no time limit prescribes when a qualified medical expense claim must be filed.

The ability to use an HSA as a tax-favored investment vehicle depends on two things. First, when a medical bill falls due, the taxpayer must be capable of paying it with funds outside the HSA. The investment benefit decreases as the taxpayer draws on the HSA funds. Second, taking tax-free withdrawals depends in part on the taxpayer's incurring medical costs that can be reimbursed from the HSA upon submission of receipts. Since some taxpayers and their families are relatively healthy, their health decreases the flexibility of the HSA as a tax-favored investment vehicle from which funds can be drawn upon quickly and without penalty. However, even healthy taxpayers face regular health and dental expenses, which include unprescribed over-the-counter medicine and menstrual care products, that qualify for reimbursement. To the extent that a taxpayer pays these costs out of pocket and can substantiate they were paid, these paid but unreimbursed costs allow the taxpayer to later draw on his or her tax-favored investment as needed. One way to view paying qualified medical expenses with non-HSA funds is that these payments become highly flexible, heavily tax-favored investments. Of course, if non-HSA savings or after-tax investments are not available to pay medical costs, HSA funds can be used. But using HSA funds to pay qualified medical expenses should be a last resort, not the default strategy.

Examples of applying the strategy

Example 1: M (age 25) and J (age 24) married in 2021. M works for a large public accounting firm, and J freelances as a graphic design artist. Starting in 2021, each year, M's employer pays the cost of family HDHP coverage and contributes $2,000 to M's HSA. In addition, M and J annually contribute $1,000 to the HSA and claim a deduction for this amount on their joint tax return; this $1,000 pretax contribution is considerably smaller than would be required for traditional full- coverage health insurance. The net annual cost is $700 after considering their 30% marginal tax rate. M and J are in good physical condition, but annual vision, dental, and menstrual care; wellness checks; and over-the-counter medicine costs total $2,500 per year, which M and J carefully document and pay out of pocket without requesting reimbursement from the HSA. The HSA funds are invested and earn 8% annually. The couple buy a house in 2027 after having a baby in 2025. The couple planned and paid for the $6,000 cost of having the baby out of pocket, including prenatal care and two hospital nights. (2) By 2027, the balance in the HSA has grown to $27,839, which includes $6,839 of tax-free income. In 2027, the couple submit reimbursable receipts that total $23,500, the proceeds of which finance a portion of the down payment on the house. (3)

Example 2: B (age 51) and G (age 47)...

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