Healthcare FSAs vs. Health Savings Accounts. What's the Diff?

Unlike a healthcare FSA, money contributed to an HSA can be invested much like contributions to a 401(k) or an IRA. And unlike an FSA, HSA contributions don’t fall in the category of “use-it-or-lose-it” if not spent in a given plan year.

My apologies for this rather wordy blog, but for those who might qualify for a Health Savings Account (HSA) and who are searching for beneficial tax-deferred retirement vehicles, it just might be worth your while to read. To watch the video, click here.

HSA vs. Healthcare FSA

Our discussion last week about healthcare Flexible Spending Accounts (FSAs) spurred some queries about a related subject, Health Savings Accounts (HSAs). Are they one and the same? Because HSAs are frequently confused with FSAs, let’s briefly discuss the major differences.

Although both are tax-advantaged accounts for healthcare savings, they are quite different. Unlike an FSA, money contributed to an HSA can be invested much like contributions to a 401(k) or an IRA. And unlike an FSA, HSA contributions don’t fall in the category of “use-it-or-lose-it” if not spent in a given plan year. Unused HSA contributions can be carried over from year to year, year after year. That’s right, a plan participant doesn’t need to spend HSA money during any specific timeframe. This makes HSAs excellent vehicles for saving and investing to cover healthcare expenses after retirement – when such expenses are likely to increase. You must have a qualifying high-deductible health plan to enroll in an HSA. Not all employers offer HSAs, but some of those who do make contributions on their employees’ behalf. If your employer does not offer such a plan, HSAs are available with any number of reputable financial institutions.

There is no deductible or out-of-pocket maximum to save in a healthcare FSA. The “use it or lose it” clause is the limiting factor here since most of the money in an FSA has to be used during the same plan year. An FSA participant simply can’t accumulate a large balance in this type of account because of the “use it or lose it” feature. With an HSA, there is no requirement to use the money contributed every year. In fact, the characteristics of an HSA actually encourages the participant to contribute more each year.

The Fine Print...

Problem is, unless folks are enrolled in a health insurance plan with an annual deductible of at least $1,400 for single coverage ($2,800 for a family), they aren’t eligible to contribute to an HSA. However, tons of people meet this standard, but few take advantage of the numerous benefits an HSA offers. Many simply aren’t aware of its several advantageous features: no “use-it or-lose-it” clause to deal with each year; its tax-deductible contributions, which can be invested; and qualified healthcare expenditures you make from this account are tax-free.

In short, an HSA is a tax-advantaged savings and investment account designed to help folks save for their out-of-pocket medical expenses. The central requirement for participation is having a qualifying high-deductible health plan. For 2020, it’s an insurance plan with a deductible of at least $1,400 for single coverage ($2,800 for family coverage). And in 2020, the plan must also conform to an out-of-pocket maximum threshold for an HSA-qualified health plan of not more than $6,900 for self-only coverage or $13,800 for family coverage. An out-of-pocket maximum is a cap, or limit, on the amount of money you have to pay for covered healthcare services in a plan year. If you meet that limit, your health plan will pay 100% of all covered healthcare costs for the rest of the plan year.

Know Your Limits

Contribution limits, which must be made by April 15, are set annually by the IRS. In 2020, they're $3,550 for self-only coverage and $7,100 for a family (HSA participants 55 or older can contribute an additional $1,000 as a catch-up contribution). Be aware (but it’s a good thing) that if your employer makes HSA contributions on your behalf, these are included toward the annual limits.

Invest the Funds!

Contributions made to an HSA don’t have to remain idle – as they would in an FSA. That’s one of the beauties of this type of account. The money can be invested, usually in a selection of options not unlike 401(k) choices. Of course, a participant can leave it in cash or a near-cash equivalent, but why do that? If the money is wisely invested, why not pay certain healthcare costs out-of-pocket and leave your invested dollars intact? If affordable, this practice would allow the participant to use an HSA’s investment feature to build a long-term health savings account… only one of several tax advantages offered by HSAs, some of which aren’t available with other “tax-advantaged” vehicles. Curiously, this investment capability is not widely understood and practiced. Only a small percentage of HSA participants invest their fund accounts – in my mind, the most compelling reason to enroll in an HSA, and let’s discuss why.

HSA Tax Benefits

If you qualify to enroll in an HSA, and then if you invest all of your annual contributions, you’ll be blessed with certain tax advantages that “collectively” aren’t available with other tax-deferred investment vehicles. Consider one of my endless examples using a Bankrate investment calculator: Suppose that at age 25 your qualifying family joins an HSA and contributes the tax-deductible annual maximum of $7,100 (about $592 per month). Suppose further that this money is invested at 7%, compounded annually and grows tax-deferred (just like it would in an IRA, 401(k), or other retirement vehicle) for 25 years. Then suppose, after 25 years, tax-free withdrawals from the HSA (now totaling $469,400) are available to pay for qualified healthcare expenses. What a huge stress-reliever that would be.

Viewed another way, your HSA combines the tax-free withdrawals of a Roth IRA with the tax-deductible contributions of a traditional IRA or 401(k). Or you could simply let it continue to grow another 15 years to provide you with an even larger nest egg ($1,472,000) for healthcare expenses going into retirement at age 65. Even after assuming a 2% annual inflation rate, you would still have spending power equivalent to $667,000 in today’s dollars. And don’t forget the $284,000 of contributions from age 25 to 65 that your family has been able to exclude from income. The only kicker is that the money must be spent on qualified healthcare expenses UNTIL YOU TURN AGE 65!

Qualified Expenses

So what qualifies as tax-free healthcare expenses? Because the IRS provides an exhaustive list in Publication 502, I’ll only mention a few: Prescription medications, nursing services, dental and eyecare, hearing aids, surgical expenses, and yep, long-term care is on the list. By and large, HSA withdrawals must be spent on “qualified” medical expenses as defined by the IRS. However, as subtly mentioned above, once you reach age 65, money can be withdrawn for any reason, but there’s a tax kicker. If not used for qualified medical expenses, withdrawals after age 65 will be treated as taxable income, but no penalty will apply. In short, “over age 65 HSA withdrawals” will be treated the same as withdrawals from a traditional IRA or 401(k), although it's worth mentioning that the penalty-free withdrawal age for most other retirement accounts is 59½ years old. This treatment is another reason why HSAs make good retirement savings vehicles.

But be advised, there is no such thing as a flawless investment account. HSAs, too, suffer the imposition of penalties for “non-qualified withdrawals”. Most prominently, if a participant under age 65 withdraws money to pay for a non-qualifying expense, the result is a stiff 20% early withdrawal penalty – double that of 401(k)s, IRAs, and most other retirement plans. Why? Such non-qualifying expenditures defeat the purpose of HSAs and are discouraged.

Use It

To summarize, the characteristics that make an HSA such a good retirement savings vehicle includes the enhanced family contribution limit of $7,100 ($1,100 greater per annum than for a 2020 IRA); no maximum income threshold as with an IRA; upon retiring, no fretting about Required Minimum Distributions (RMDs) after reaching age 72 as is the case with other tax-deferred retirement accounts; and don’t forget the absence of that onerous “use it or lose it” provision.

Contributions can be carried over year to year, year after year and can be invested just like IRA and 401(k) contributions. It’s a dollars-and-cents game, folks. Studies show that retired couples should prepare to spend upwards of $300,000 (in today’s dollars) on out-of-pocket healthcare expenses in retirement… all the more reason, if qualified, to consider this tax-deferred investment combined with the ability to take tax-free distributions to cover qualified medical expenses. I’ll close with another boring example: If your tax bracket after retirement is 25% (very possible), without an HSA you would have to withdraw $400,000 from IRA or 401(k) tax-deferred accounts to scrounge up the aforementioned $300,000. With an HSA, you could cover those medical expenses with a $300,000 tax-free withdrawal.