A Boring Way to Save Over $100,000 in Taxes

Apr 17

Achieving your financial goals requires learning about some things that are boring. Health savings accounts, or HSAs, are boring, except perhaps to financial planning nerds.

They are yet another in a long list of accounts created by Congress and the IRS to offer us carrots for actions, like saving, that will improve our future selves. As the years go by, it is easy get numb to the various flavors of accounts, contribute to the 401(k) and call it a day.

Despite their inherent dullness, I encourage you to spend a few minutes learning about how HSAs can help you accomplish something decidedly more interesting: tax savings of more than $100,000 with consistent long-term use.

What is a Health Savings Account?

A Health Savings Account (HSA) is a special type of savings account you can set up when you have high-deductible health insurance. To incentivize you to save for health care costs, HSAs have unique tax benefits that are worth more as you earn more. Like most things from the Internal Revenue Service, there are a number of rules governing use of HSAs.

High-Deductible Health Plan Requirement

To set up an HSA, you must be enrolled in a high-deductible health plan (HDHP). This is a health insurance plan with a minimum deductible and a limit, or maximum, on out-of-pocket costs.

The minimum deductible is the amount you pay for health care items and services per year before your plan starts to pay. For 2024, the minimum deductible is $3,200 for family coverage, but the actual deductible is often higher.

The maximum out-of-pocket costs are the most you’d have to pay per year if you need more health care items and services. For 2024, HDHPs can have an out-of-pocket maximum of up to $16,100, though plans offered by employers are often less than this.

When you are choosing a healthcare plan, high-deductible health plans will usually be prominently identified with “HDHP” in the plan name or description. Not all plans with high deductibles meet the IRS definition, so be sure to confirm with your employer or the insurance company if you are not sure. Ask whether the plan is “HSA-qualified”.

Maximum Annual Contribution Amounts

You, your employer, or both can contribute funds to your HSA up to a certain limit set by the IRS each year. The annual contribution limit for a family plan is $8,300 for 2024.

Withdrawals

In exchange for the special tax benefits, the IRS restricts how you can use the money you place in an HSA. You can withdraw funds at any time to pay for so-called qualified medical expenses not covered by insurance, including deductibles, co-payments and prescriptions. There is a long list of qualified medical expenses in IRS Publication 502. For example, hearing aids are qualified while cosmetic surgery is not.

If you withdraw money for non-medical expenses before you turn 65, you'll incur a penalty and pay taxes on the amount withdrawn. After you turn 65, you can continue to use your HSA savings for medical expenses, but you can also withdraw money for non-medical expenses without penalty (though you'll pay income tax on those withdrawals, similar to a traditional IRA).

Why an HSA

An HSA is a rare creature in the alphabet soup world of tax-favored savings accounts. Like a traditional IRA, you get a tax deduction for the money you contribute each year, up to the annual maximum. Unlike a traditional IRA, however, the money, along with any growth, is not taxed when you withdraw it, so long as you use the funds for qualified healthcare expenses.

Importantly, you can use funds you withdraw to reimburse yourself for qualified healthcare expenses you have paid for at any time since the HSA was opened. In other words, the money does not have to be withdrawn at the time you actually incur the expense. Letting the account grow tax free is key to unlocking its power to increase your wealth.

Many people in higher tax brackets may look at the annual contribution limits ($8,300 for families in 2024) and decide that the juice is not worth the squeeze. An example helps illustrate how a long-term HSA strategy can add up. Consider someone who saves the annual maximum in an HSA for twenty years, and funds any out-of-pocket medical costs during that period with other savings. The following table illustrates the ending balance, compared to saving the same amount in an after-tax account.

Assumptions: 5% annual return on investments, 2.5% annual contribution increase; ordinary income tax rate of 34% (28% federal, 6% state) and capital gains tax rate of 24.8% (15% federal, 3.8% net investment income tax, 6% state). To simplify the calculation, it is assumed that all gains in the taxable account are taxed at capital gains rates at the end of the period, which is favorable to the after-tax calculation.

Compared to after-tax scenario, HSA use saves income taxes of $107,228, which directly adds to your net worth. Of course, this assumes you have total family healthcare expenditures over your lifetime of at least $353,718 that you can apply the HSA funds against. According to a recent Fidelity study, a couple retiring now at 65 can expect to spend $315,000 on healthcare in retirement. Coupled with the ability to reimburse yourself for healthcare expenditures incurred before retirement (discussed below), this assumption appears reasonable.

Is an HSA Savings Strategy Right For You?

When considering an HSA, take a two-step approach. First, decide whether a high-deductible healthcare plan is right for you based on your health situation. Only once you have answered yes to this should you consider whether an HSA optimization strategy is appropriate.

First Step: Does a High-Deductible Health Plan Fit Your Health Needs?

Healthcare needs should be a deciding factor in any health plan choice. A high-deductible health plan makes sense for many even if you are not optimizing it for long term wealth. A HDHP will have smaller premiums than plans with lower deductibles, which represents a direct monthly savings if your healthcare needs are low. Also, employers often contribute to HSAs on behalf of employees who select the HDHP plan option.

If you have a chronic health condition that involves ongoing care, an HSA may not be the best option. Also, if you have a year in which you know you will have an expensive medical procedure (like a pregnancy or elective surgeries) you may save by electing a plan with a lower deductible and higher premiums. Many companies have online calculators that can assist with this decision. Don’t try to model it down to the last penny and all potential tax scenarios; instead, make a reasonable estimate taking into account the difference in monthly premiums and move on.

Keep in mind that if your employer offers both high and lower deductible plans, you can switch from one to the other each year during open enrollment, keeping any previous HSA intact. You can always implement the HSA optimization strategy later if it makes sense.

Second Step: Is it Time to Optimize?

Here are some questions to ask in deciding whether an HSA optimization strategy is right for you:

Are you saving enough in your retirement accounts to maximize any match your employer offers?
Do you have after-tax savings sufficient to fund the annual HDHP deductible?
Are you saving enough to meet short or medium term non-healthcare goals like a home purchase or debt repayment, with an amount left over to save each month?

If the answer to these questions is yes, then the steps to implement an HSA optimization strategy are simple:

Enroll in a HDHP during your next annual enrollment period and open an HSA, if you don’t already have one
Set up a monthly contribution to the HSA that adds up to the annual maximum set by the IRS, which is updated annually
If available, select a diversified investment option for the HSA funds (such as an index fund or a target date fund based on your retirement age)
Pay ongoing healthcare expenses out of non-HSA savings
Scan your out-of-pocket receipts with your phone and save them to a dedicated cloud folder, organized by year
Each year during enrollment season, ask whether a HDHP continues to make sense based on recent healthcare history and projected healthcare usage (see “First Step” above)
Repeat each year

The End Game

After years of tax-free contributions and growth, you should have a sizable HSA account balance. How do you use it? You have two good options:

First, you can withdraw money to fund future healthcare expenses, including:

COBRA premiums (if you leave your job before qualifying for Medicare),
Medicare premiums (not including Medigap policies); and
Long-term care premiums (up to a limit).

This option can be a good tool to alleviate worry about insurance costs when making a life or career decision.

Second, you can withdraw an amount to use for any purpose equal to the total of all those receipts you scanned and saved over the years. You are paying yourself back for those earlier expenditures. This is the option that makes a long-term HSA strategy special. You benefit from the initial tax deduction, tax-free growth and, finally, tax-free withdrawals. Be sure to keep track of which receipts you match withdrawals against to avoid double-dipping.

You can also withdraw funds for any purpose after age 65 in excess of cumulative healthcare expenses, but you will have to pay tax on the withdrawals, making them similar to an IRA or 401(k) balance. If someone other than your spouse inherits an HSA, the account will be liquidated at death and taxes owed, so they are not good legacy assets.

The Bottom Line

At first glance, HSAs appear to have a narrow purpose: a savings account for co-pays and deductibles. Repurposed as a general savings vehicle, they can be a unique tool to power savings and long-term financial flexibility.

Jeremy Ouchley