I briefly discuss the eligibility rules for Health Savings Accounts (HSAs) in another article and will not cover them here. The bottom line is: if you are eligible for an HSA, you should have one.
HSAs are triple-tax-advantaged. Money from wages goes in tax-free*, grows tax-free and then comes out tax-free if used for medical expenses. This is the only investment vehicle like that. Because of this tax treatment, I came across two subtle (dare I say secret) characteristics of an HSA which I describe via spreadsheets below.
*Note: in addition to Federal income tax avoidance, HSA contributions made through employer payroll deductions also avoid FICA taxes if you make less than the annual Social Security Tax salary cap. However, this may also lower your social security benefit. In some states, state income tax is also avoided. I do not consider either of these in this article (but you can… in your own spreadsheet!).
HSA Spreadsheet Secret #1: Spending HSA Money Can Generate More Money
I consume a lot of personal finance media and often hear (and might even repeat): “Don’t spend HSA dollars, invest them. Pay current medical bills with cash reserves and save the receipts for much later HSA reimbursement in retirement.” This advice is not bad, but it comes with an important caveat: it depends on how tight your finances are.
Let’s look at a yearly balance sheet of a married couple with an income that exactly covers expenses (including medical) after taxes and credits.
Here is what their balance sheet looks like if they fund an HSA with $1000 and use it to pay medical expenses.
Now there is an extra $220 in after-tax dollars. Since they don’t need this money for expenses, what should they do with it? They could just leave it as after-tax cash and invest it that way. But let’s look at two HSA-related options.
Option 1: Only reimburse part of their medical expenses from the HSA.
Rather than the full $1000, they might only reimburse themselves for $780 of their medical expenses. This leaves $220 in their HSA, but doesn’t change their net worth.
Option 2: Reimburse the full $1000 in medical expenses, but overfund the H SA.
Another, much better, option is to reimburse the full $1000 in medical expenses while contributing more than $1000 to the HSA such that they can still balance their budget (net take-home of $0). The initial HSA funding for this is $1282. After reimbursement, $282 is in their HSA. 28% more than $220.
So, in this tight-budget example, spending HSA dollars creates more net worth!
Where does the effect of money creation from spending HSA dollars end? When you reach the HSA yearly funding limit. For this couple’s finances, they run up against the HSA funding limit (for a family) of $7200 at around $6000 in reimbursed medical expenses.
This leaves them with $1200 in their HSA and $49 in cash.
What if they have additional medical expenses? This leads us to our second secret.
HSA Spreadsheet Secret #2: The Roth HSA
Once the HSA limit is hit, medical expense reimbursement can no longer magnify money. However, submitted expenses can still turn pre-tax HSA dollars directly into tax-free cash. Then you can invest those dollars, if eligible, in a Roth IRA! So instead of the usual after-tax dollars, untaxed dollars fund the Roth IRA! I call this the Roth HSA!
Strangely, I have not seen or heard my Roth HSA concept discussed anywhere else. I find this a little surprising. Perhaps the financial gurus think it too complicated. Or that it doesn’t provide much financial benefit. But the only difficulty I see is meeting the eligibility rules for both HSAs and Roth IRAs. If so, I think the actual implementation process is fairly simple and worth the effort.
In another article on this site, I prioritized some common investment choices in this order:
- Put enough pre-tax money in a company 401k to get the full company match
- If eligible, fund an HSA. To the limit if possible.
- If eligible, contribute to a Roth IRA…I will now add, if you can, make this a Roth HSA!
Let’s try to quantify these choices with a modified version of our married couple’s budget example.
In this iteration, their finances are not as tight, with only $80,000 in expenses. This initially leaves them with an annual net worth increase of $11,010. If they choose to contribute 8% to their 401k, which gets them the full company match, they can add an additional $3201.
They still have a budget surplus. What if they add more (unmatched dollars) to their 401K? In their case, they can contribute an extra $5000 and still balance the budget. Unfortunately, based on a predicted tax rate in retirement that is higher than their current top bracket, they lose value.
What if they moved that $5000 to an HSA instead? Given the expectation that HSA money will eventually come out tax free, their -$400 loss is now a +600 gain (a $1k difference).
But they are not at their HSA max yet, so they have not fully magnified their money!
A quick side note: The $5000 figure I use approximates what an average family spends on out-of-pocket medical expenses each year.
So now let’s say our married couple maxes out their HSA, then reimburses themselves $5k of that. Now they have increased their annual net worth by an additional +$264. They also have a decent budget surplus, which they can use to fund a Roth IRA.
Since their budget surplus comes from tax-free, reimbursed HSA money, their Roth IRA is now a Roth HSA! More medical expenses submitted this year means more for the Roth HSA.
Here is another very crucial consideration regarding my Roth HSA concept. The medical expenses don’t have to be from the current year. They can be from any prior year back to when the HSA was first created. This is important because sometimes the various Government annual limits on retirement accounts can get in the way of my Roth HSA technique. That’s usually a good thing, because it often means lots of income and savings those years. But since medical expense receipts can be saved up, there is nothing wrong with waiting for a better time to use them.
Here is one example of how that might play out. Let’s give our married couple more income. Each year with finances like this, they can max out both their HSA and their Roth IRA without submitting medical expenses.
However, some of their income is in the 22% tax bracket, which is higher than the tax rate they anticipate in retirement. They could decide to put another $8900 into their 401k to get to the $19.5k annual limit (if they both have 401k access, this limit is doubled). This improves their net worth by a small amount ($143). More significantly, it gives them the opportunity to transfer around $6500 of untaxed HSA money into Roths! They will need enough saved-up medical expenses, so perhaps they develop a plan to implement this strategy every few years.
You might have noticed that transferring money from an HSA to my Roth HSA does not increase overall net worth. Then why do it? The reason is because money in an HSA is subject to many more restrictions than money in a Roth. And it’s the rules regarding earnings that are most relevant, because over time earnings can compound and become quite large compared to contributions:
- HSA earnings are only potentially tax-free (because they must be used for medical expenses). Roth earnings are always tax-free when the age limit and 5-year Roth ownership rules are met.
- HSA funds (including earnings) can be treated like income from a Traditional IRA and used for non-medical expenses (after paying taxes) starting at age 65. Roth earnings are available without restriction after age 59.5 and are not treated as income.
October 2022