I’d like to share with you an idea that could save you $10,000 or even $100,000 by the time you retire. I have spent many years researching personal finance and one of the most under-rated retirement accounts is the Health Savings Account (HSA). It took me several years to learn that an HSA plan is superior but as of 2018, my family is contributing the full $7,000 contribution limit. Few individuals are taking advantage of this lucrative tax benefit account and I will try to explain why that is a mistake.
Using an HSA account requires an individual to use an HDHP (High Deductible Health Plan). Employers and employees make contributions that are tax-free. As these contributions are made, they can be used to pay for qualified health expenses without paying any taxes.
Personally, in 2015 I used an HSA to pay for Lasik surgery (which I highly recommend). The cost was around $3,400 for both eyes, so by taking advantage of the HSA plan I was immediately able to save around $1,360 (40% of the costs). That is phenomenal, yet most people I encounter on a daily basis are not utilizing this anywhere near where they should.
Why HSAs plans are amazing
The key that most Americans are overlooking is that HSA paycheck contributions are exempt from Social Security and Medicare taxes. Here is an example: Let’s look at a typical American Family that earns $55,000 a year and has their employer to put $500 into an HSA account.
You would avoid the following taxes:
- 22% in marginal Federal Income taxes
- 5% State income taxes (Varies, from 0% – 13%, but we’ll say 5% on average)
- Social Security Tax (6.2%)
- Medicare Tax (1.45%)
Note that a 401k avoids federal and state income tax, but only the HSA shines because payroll taxes are avoided (assuming they are payroll deductions). Thus an HSA plan is 7.65% better than a 401k plan on a dollar for dollar basis. A dollar put into a 401k plan is only worth 92 cents compared to an HSA dollar.
Why HSA plans are underutilized
A lot of people get hung up on HSA plans because they have false assumptions. First, many people are young and healthy and they don’t have a lot of health expenses. So from their respective, it doesn’t make sense to put money into an HSA. Second, most people think that HSA plans can only be used for health expenses.
This isn’t great reasoning because as people age, their healthcare costs tend to go up dramatically. An individual could very well go through several hundred thousand dollars of healthcare expenses in their later years.
Additionally, once you turn 65 you are allowed to use the HSA plan for non-healthcare expenses. At that point, you would need to pay federal and state income taxes on the HSA plan (just like you would a 401k). The HSA is still superior in this case though because you avoided Social Security and Medicare taxes. And if an individual were wise, he would relocate to a zero income tax state before drawing his HSA.
There are even more advanced HSA loophole strategies that I have not used personally. Technically, the HSA laws do not require expenses to be reimbursed immediately. For instance, if you have a health care expense you can pay cash, save the receipt, and then file an HSA reimbursement claim potentially decades into the future. This allows you to compound tax-free gains in your HSA for long periods of time.
One more excuse I have seen for not using an HSA plan is that their current HSA plan does not offer them good investment choices. Ideally, an individual could put the money into bond or S&P Index funds. They avoid putting money into their HSA because it would sit in a low interest yielding savings account. Surprisingly, this is not a valid reason to avoid HSA plans. HSA plan balances can be rolled over without even leaving an employer. For instance, you could open an HSA account at a preferred investment brokerage and then request funds to be transferred, all without leaving your current job. Note that this typically incurs a transfer fee (in many cases around $50). You wouldn’t want to do this frequently, just on a periodic basis.
There are a few caveats that I can think of where a 401k plan is better than an HSA: Employer match.
If your employer offers a 401k match, then you should always contribute to that amount as it is essentially free money. The other situation is when families expect to have large medical expenses. Under these circumstances, it probably makes sense to forgo a High Deductible Health Plan \ HSA and instead utilize lower deductible health plans.
An HSA can only be used with a high deductible healthcare plan (HDHP). If your family has a situation that necessitates high medical or prescription costs, then an HSA may not make sense.
Finally, a typical 401k plan allows withdrawals at 59 1/2 whereas the HSA only allows them after age 65 (in certain circumstances, this could matter).
There is a lot of arcane knowledge regarding HSA plans that few people fully understand. If they did, I think we would clearly see a decline in 401k usage and an increase in HSA plans. In summary, few Americans are taking advantage of this lucrative program. Hopefully, this article can help change some minds.