Recently, a reader named Charlie left this comment on Stealth IRA: Health Savings Account:
“I love how this is written assuming no large medical expenses. Have kids 🙂 You’ll eat through most, if not all of your HSA contributions every year. I know I have for the last two years.
I’m glad I can pay our medical expenses with pre-tax dollars, but I no longer consider my HSA account as a stealth IRA.”
It brings up a great question: Should I use my HSA to pay for out-of-pocket health care expenses today or should I instead pay for out-of-pocket health care expenses with current cash flow and let the HSA money compound and grow?
Those of us with a Health Savings Account (like Charlie) know that it’s an excellent account. If you use the HSA money for health care expenses, it’s triple-tax-advantaged. The money isn’t (i) taxed when contributed; (ii) taxed as it grows; or (iii) taxed when used, if spent on a qualified medical expense. That makes it better than a Traditional IRA, Roth IRA, 401(k) or 529 accounts.
The Health Savings Account is such a good deal that money should be contributed to an HSA in preference to any other retirement account except for contributions matched by your employer.
Even if you end up with perfect health or never have any medical expenses, after you reach age 65 you can withdraw money from a Health Savings Account in the same way as a Traditional IRA and use the funds for whatever purpose you want, such as covering living expenses or a trip to Paris. In other words, the best case health scenario means at worst the HSA is another Traditional IRA.
Two schools of thought on using HSA money
So, we’ve established that the Health Savings Account is a must-have if you have a high-deductible health insurance plan. But, how should you use it?
There are primarily two camps: (1) Use the HSA money to cover current out-of-pocket expenses; or (2) Use cashflow to cover current out-of-pocket costs, save the receipts for future reimbursement and let the money grow in the HSA.
Requesting reimbursement for healthcare expenses 30-40 years after you originally incurred the expense is allowed. There’s no requirement that you claim HSA reimbursements during the same calendar year you incur the expense. This issue came up specifically in IRS Notice 2005-40 (emphasis mine):
Q-39. When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?
A-39. An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year..
Camp 1: Pay current expenses from the health savings account
Paying for current expenses is arguably the original intent of the Health Savings Account. You make tax-free contributions to the HSA and then you use that money to pay for medical expenses as-and-when occurred. It’s how Charlie is using the account, which is why the kids are eating through the annual HSA contributions.
If you’re not maxing out your retirement accounts, then it almost certainly makes sense to pay for your current expenses from the Health Savings Account.
For example, imagine a $100 qualified medical expense and a 25% marginal tax rate. You’re deciding between using $100 from the HSA or $100 from your pocket. If you take $100 from the HSA to pay for the expense today, that leaves the $100 in your pocket to contribute to a Roth IRA or $133 to contribute to a 401(k).
If you take $100 from your pocket to pay for the expense today, that leaves you with the right to withdraw $100 from your HSA account at any time in the future (and you’ll be able to spend that $100 however you want).
In the first scenario, if you invest the $100 into a Roth IRA, you’ll not only be able to spend the $100 in retirement on anything you want, you’ll also be able to spend the investment gains from that $100 tax-free as well. The math is the same if you invest the $133 into a 401(k) after adjusting for a 25% income tax paid on withdrawal in retirement.
In the second scenario, you’re only able to withdraw the $100 from your HSA. The investment gains will continue to accrue but those gains can only be used for qualified healthcare expenses (to get tax-free treatment) or else you’ll be required to pay income taxes upon withdrawal on those investment gains.
In other words, it’s better to take advantage of the Roth IRA and get the $100 + investment gains completely tax-free than it is to get $100 from the HSA + pay taxes on the investment gains or be limited to using the money for qualified medical expenses.
There’s also another compelling reason to pay current expenses from the Health Savings Account. If you want to withdraw the money in the future, the burden is on you to show that the costs haven’t already been reimbursed in another way and that you haven’t taken a deduction on those expenses.
Many people do not want that burden.
Camp 2: Pay current expenses out-of-pocket; let HSA grow
If you’re already maxing out your retirement accounts, it makes mathematical sense to pay your current expenses out-of-pocket, save receipts and let the HSA continue to grow.
For example, imagine a $100 qualified medical expense. You’re deciding between using $100 from the HSA or $100 from your pocket. If you take the $100 from the HSA to pay for the expense today, that leaves the $100 in your pocket to contribute to a taxable investment account. You’ll be able to use that $100 in the taxable account whenever you want by selling the investment, but you’ll pay taxes along the way on capital gain distributions and dividends, as well as capital gains taxes when you sell.
If you take the $100 from your pocket to pay for the expense today, save your receipts, and let the HSA continue to grow, you’ll be able to withdraw the $100 from the HSA at any time. However, the investment gains from the $100 will continue to accrue inside the HSA. You will be able to use those investment gains towards qualified medical expenses (tax-free), or you’ll be able to withdraw them after 59½ at ordinary income tax rates.
In my review of other writers on this topic, I haven’t seen many point out that by making the decision to leave the funds in an HSA you’re trading capital gain tax treatment (had the $100 been invested in a taxable account) vs ordinary income tax treatment (if you end up withdrawing the money from the HSA after 59½ for anything other than qualified medical expenses). That’s not a great trade to make.
I think this point isn’t mentioned because most assume that medical expenses will be significantly high in retirement that it shouldn’t be a problem to find qualified medical expenses in the future. After all, you can use an HSA to pay for Medicare premiums. After you hit 65 and qualify for Medicare, that’s a significant recurring qualified medical expense for your HSA.
For that reason, I think it’s reasonable to assume that you’ll be better off by keeping the money in the HSA and taking advantage of any investment gains within the shelter of the Health Savings Account.
Overfunding your health savings account
It’s possible that you can contribute too much money to your Health Savings Account, but I don’t think it’s something many lawyers should be worried about. If you get to the end of your life and have excess HSA funds, that’s a wonderful problem to have. The account can still be treated as a Traditional IRA, so you can make withdrawals and spend as needed.
If you die with a balance, your HSA transfers to your spouse. If you don’t have a spouse (or elect someone else to be the beneficiary of the HSA), they’ll inherit a fully taxable lump sum amount subject to ordinary income taxes. While I’m sure they’ll still be happy to receive it, if it’s a kid in her peak earnings years, she may have a high marginal tax rate applied against it.
There’s also the problem that your estate may have the unfortunate task of needing to sort through your old receipts to figure out how much of the HSA can be withdrawn tax-free, but there’s no reason to think that the estate wouldn’t be able to do that.
One way to simplify this scenario would be to create a donor-advised fund (if you intend to leave a certain portion of your estate to charity) and make the DAF the beneficiary of your HSA.
How do I handle my health savings account?
Given the relatively low contribution limits, I plan to continue to max out my Health Savings Account indefinitely. I’d be pleased if I end up in a situation where I have ample funds left.
I am paying for medical expenses out-of-pocket and keeping receipts as I go. I have a spreadsheet where I record each medical expense and then a digital folder where I save all of my receipts.
I understand why some people are reluctant to deal with this paperwork but keep in mind that you don’t have an affirmative defense to get access to the HSA funds, you need a record in case the IRS audits you in the future. Like many things related to the IRS, reimbursing yourself for HSA expenses relies on the honor system.
Joshua Holt is a former private equity M&A lawyer and the creator of Biglaw Investor. Josh couldn’t find a place where lawyers were talking about money, so he created it himself. He knows that the Bogleheads forum is a great resource for tax questions and is always looking for honest advisors that provide good advice for a fair price.