Are Health Savings Accounts Too Good to be True?

Signed into law in 2003, the Health Savings Account (HSA) took a while to attract attention. But in recent years, their tax advantages have been noticed by more and more people. Are HSAs too good to be true? NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

HSA 101

To take advantage of an HSA, an individual or family must be covered by a qualifying high-deductible healthcare plan. An HSA allows pretax contributions, tax-free compounding (ah, the Amazing Power of Compounding), and of course, the ability to take tax-free withdrawals to pay for those qualified healthcare expenses. These benefits alone make HSAs equally or even more attractive than other retirement savings vehicles like employment-related 401(k)s and those ever-popular Roth and Traditional IRAs.

Too Good to be True?

But is gets better! HSA contributions are not “use-it-or-lose-it”- money you contribute can be carried over from year to year, year after year. Better yet, contributions can be invested much like those in a 401(k) or an IRA. This makes HSAs excellent vehicles for saving and investing to cover healthcare expenses after retirement – when such expenses are likely to increase. However, most qualifying folks park contributions in savings accounts to cover out-of-pocket healthcare expenses…their intended purpose. But as familiarity grows about their value as long-term investment alternatives, HSA assets increasingly find their way into long-term securities.

And, we can't ignore the HSA's ever-so-generous withdrawal feature. For example, in the instance where your HSA account balance exceeds your expected healthcare costs, you can withdrawal money out without abrogating the tax benefits of the HSA.

Pre-65 Withdrawals

For those who are using HSAs as long-term investment tools, it's often wise to utilize non-HSA assets to cover healthcare expenses. Why? Taxable assets don't enjoy the tax benefits that assets in an HSA vehicle do. So if financially feasible, use taxable assets to cover healthcare costs that occur along the way and let your HSA assets continue to enjoy tax-advantaged growth…and the associated Amazing Power of Compounding.

The good news is, even if you’ve paid for healthcare expenses with non-HSA assets in prior years, you can later…even much later…make tax-free withdrawals for equivalent non-healthcare expenses (but keep those receipts for the earlier healthcare costs paid with non-HSA assets). That’s right, an unlimited amount of time can occur between when a healthcare cost occurred and when you can reimburse yourself. But again, the withdrawal will be tax-free only if you have documentation of the prior expense.

Need an example?

You paid $2,500 out-of-pocket (i.e., using non-HSA funds) to cover healthcare expenses in 2020 instead of using HSA funds, which allows you to fatten up your HSA account.
In 2021 and 2022 you continue to add funds to your HSA.
In 2023, you need to replace a non-healthcare expense air conditioning unit in your home costing $2,500. Because you have documentation supporting the 2020 out-of-pocket healthcare expenditure, you can pull the $2,500 from your HSA tax-free to pay for the A/C expenditure…if you wish to do so.

You’re better off leaving the money in an HSA, but on occasion HSA withdrawals are better than other forms of emergency fundings, which gives me another opportunity to remind you of the importance of Rainy Day funds. And fair warning, in order to qualify for this particular exit strategy, the HSA participant must have established the HSA…and made the necessary contributions…before incurring the healthcare cost they want to cover.

Post-65 Withdrawals

After age 65, an individual can make withdrawals from an HSA for any reason. However, if withdrawals are made for non-healthcare expenses, they'll be taxed the same as IRA or 401(k) withdrawals.

Despite this post-65 taxable issue, the HSA has provided its owner with another retirement savings vehicle that enjoyed a free ride on pretax contributions and tax-free compounding to the point of withdrawals. And even at this late date, if you’ve use non-HSA assets to cover ancient healthcare expenses…and if you’ve saved those ancient receipts…you can still pull money out of the HSA, tax-free, to reimburse yourself for such out-of-pocket expenses.

Spoiler Alert

Unfortunately, despite its pre-death flexibilities, inherited HSAs don't have the tax flexibility that IRAs do. For example, if a spouse is the HSA’s beneficiary, he or she can continue to take advantage of the HSA’s generous tax benefits. But if someone else is the beneficiary, the HSA and its tax benefits cease to exist upon the death of the original owner.

In short, the inherited amount becomes fully taxable to the non-spouse beneficiary. For that reason, it makes sense to prioritize the spending of HSA assets, particularly in retirement.