Here’s the best way to use a health savings account, which offers a triple tax advantage

Health savings accounts can be a powerful way to build wealth and prepare for medical expenses in old age, if used correctly.

HSAs have a three-pronged tax benefit. Contributions and investment growth are tax-exempt, as are withdrawals if used for eligible healthcare expenses.

Even if a withdrawal is not health-related, the account holder will only have to pay income tax on those funds, thus turning the HSA into an account with tax advantages similar to a 401(k) plan. ) traditional or to an Individual Retirement Account.

“I almost don’t think of them as health savings accounts, but as deeply tax-advantaged retirement accounts,” Andy Baxley, a Chicago-based certified financial planner told the Planning Center.

According to financial advisors, the ideal way for savers to use HSAs is to contribute the annual maximum, invest the money, and pay current healthcare costs out of pocket through other savings.

This allows time for the HSA money to grow tax-free. HSA investments are like any other retirement account, with diversified stocks and bond mutual funds, for example.

However, most people do not invest their HSA savings. Instead, they use HSAs like a bank account and withdraw money as needed to pay current medical bills.

According to the Benefits Research Institute, only 9% of account holders invested part of their HSA balance in 2020. The rest – 91% – held their entire balance in cash.

But that offers virtually no upside growth — a downside when retirement healthcare costs are expected to be around $300,000 for the average couple who retired in 2021, according to an estimate from Fidelity Investments.

The IRS outlines a wide variety of eligible HSA health costs, such as those associated with dental, vision, hearing, long-term care insurance premiums (subject to limits), and drugs, for example. example.

Savers who pay out-of-pocket now for healthcare costs can enjoy another HSA benefit in years to come: they can withdraw the funds from their account to reimburse themselves (tax-free) for these past expenses.

As with withdrawals from a Roth 401(k) or IRA, these HSA refunds can provide retirement income and help someone control their tax bill.

Say you’re about to move to a higher tax bracket in retirement, but you’ve spent $10,000 out of pocket over the years on medical bills. You can withdraw that $10,000 from your HSA for past costs without increasing your taxable income.

(An important point: Expenses incurred before your HSA is established are not considered eligible medical expenses.)

“I think [people] often don’t realize how broad the list of things you can get reimbursed for is,” Baxley said, citing fertility treatment as an example.

He recommends creating a spreadsheet of unreimbursed medical expenses (so you know how much you can afford later) and keeping receipts for proof.

Of course, many people don’t have the financial means to use HSAs ideally.

Individuals are living longer and have had to embrace greater individual responsibility for their retirement savings as companies replaced retirement plans with 401(k) plans, for example.

Limited cash flow can mean having competing financial priorities: emergency funds, retirement plans and health savings, for example. (Individuals and families can contribute up to $3,650 and $7,300, respectively, to an HSA this year.) Paying current costs out of pocket may also not be possible, depending on a person’s financial situation. .

Learn more about personal finance:
Why 2022 was a dangerous time to retire
You can’t put money into an HSA once you’re on Medicare
IRS increases HSA contribution limits for 2023

Additionally, only those with high-deductible health plans can save in an HSA. In 2021, 28% of workers covered by employer-sponsored health insurance were enrolled in a high-deductible health plan with a savings option like an HSA, according to the Kaiser Family Foundation. (Enrollment is somewhat higher in larger companies with more than 200 workers.)

Caveats aside, those with access should try to use them as optimally as possible, the financial advisers said.

“An HSA is a no-brainer for almost anyone who has access to it,” according to Carolyn McClanahan, physician and CFP, founder and chief financial planning officer at Life Planning Partners in Jacksonville, Florida.

A high-deductible plan — and, by extension, an HSA — may not be the best choice for everyone. For example, someone with a chronic condition that results in frequent doctor visits may derive greater financial benefit from a plan with a lower annual fee.

Like any other investment account, it’s imperative to understand your financial and psychological capacity to take risks when investing your HSA funds, McClanahan said.

It means being able to weather the ups and downs of the stock market and aligning your strategy with your investment time horizon.

A young saver with the financial wherewithal to pay current healthcare costs out of pocket can afford to take risks, for example — perhaps in a low-cost, broadly diversified equity fund, McClanahan said.

However, savers who cannot afford to cover their annual deductible or maximum outlay with other savings should keep at least that amount in cash or something else conservative like a money market fund before investing. the rest, McClanahan said. . (Some HSA providers require account holders to hold a certain amount of cash before investing.)

This is especially the case for savers who are in poor health and need frequent health care, she added.

Likewise, someone nearing retirement age should probably reduce their stock allocations to avoid putting money at risk as they approach the age at which they will begin to dip into their accounts.