When it comes to medical expenses, the amount we spend each year feels pretty out of our control. We can’t just choose to avoid sickness and injury. How we pay for these unpredictable expenses, however, is something we have a say in.
Employers may offer tax-advantaged savings programs for such events, like a flexible spending or health savings account. Paying for out-of-pocket expenses this way can be hard to resist, especially when we feel like we’re in a use it or lose it situation.
Most American workers are familiar with flexible spending accounts. They’ve been around for almost 50 years. One of the hallmarks of these accounts is that the money deferred into them (max of $2,850 for health FSAs in 2022) must be spent or surrendered by the end of the year.
Congress recently passed legislation to allow for a small amount ($570 in 2022) to roll over to the next tax year, but workers have been trained to spend this money or risk losing it.
About 20 years ago (2003), Congress introduced the health savings account (HSA). Available to those with high deductible health plans, these were not intended to be used as annual piggy banks for short-term expenses. They were originally designed to act like a retirement plan for healthcare.
Nevertheless, after years of thinking of their flexible spending accounts as debit cards with 12-month expiration dates, workers used their HSAs in pretty much the same way. In fact, the average 50-year-old with an HSA only has around $7,000.i
It’s a shame because the HSA is arguably the most tax-efficient investment vehicle ever offered by the U.S. government. Here are three reasons why:
- Money can be contributed with pre-tax dollars (up to $3,650 for an individual, $7,300 for a
family for 2023, and an additional $1,000 for those over age 55) and withdrawn tax-free for
qualified medical expenses.
- The money can be invested! Compounding growth that will potentially never be taxed is an extremely powerful tool.
- After age 65, funds can be used without penalty for any purpose, even if you don’t have medical expenses to reimburse. (Ordinary income tax would apply, similar to an IRA or 401(k).)
Think Decades — Not Months
Now that you are thinking about your HSA as a retirement account instead of a flexible spending account, it’s hopefully clear that using it for short-term needs could prove very costly.
Why? Think of it this way: You wouldn’t take a withdrawal from your Roth IRA for medical expenses, would you? You can take tax-free withdrawals from your Roth contributions with no tax or penalty at any age for any reason, so why not? You avoid this behavior because you know it’s invested, and there is no limit to what it might grow to in the future (tax-free!). Why arrest that growth early?
An HSA is even better. Roth IRA contributions are made with after-tax amounts, and only the growth is truly tax-free. In an HSA, contributions are made with pre-tax dollars AND grow tax-free for future withdrawals if you have a qualified medical expense.
According to the IRS, the vast majority of out-of-pocket medical expenses are qualified medical expenses, including long-term care insurance premiums. Medicare supplement premiums are excluded, but regular Medicare premiums are allowed.
Based on the above, what are the odds that you won’t incur substantial medical costs in retirement? What are the odds that you won’t incur considerable medical costs for the remainder of your working years before retirement? That last point is key.
Keep Your Receipts
With HSAs, you don’t have to reimburse yourself in the year you incur the expense. You can
retroactively take a qualified distribution at any point in the future as long as the expense was incurred after you established your HSA.ii
Because reimbursements may occur many years in the future, you’ll want to keep meticulous records of the costs you incurred after your HSA was established in case the IRS ever asks for documentation. You’ll receive a Form 1099-SA from your HSA provider each year you take a distribution for tax reporting.
In the unlikely event that you have to take HSA distributions with no available medical expenses to reimburse (We should all be so lucky!), the distributions will be treated as ordinary income and will be taxable as such. If you are under age 65, you’ll also pay a 20% penalty. After age 65, you can think of the account like you would a traditional IRA for non-qualified withdrawals. Only income tax will apply. Again, not the end of the world.
Given that the average American between 45 and 64 years of age incurs nearly $6,500 annually in medical costs, having nothing to reimburse should not be high on the concern list. In fact, after age 65, that number is over $11,000 per year! iii
Think Long Term — But Not Forever
Finally, you’ll want to spend your HSA dollars during your lifetime. No, your heirs won’t lose it if you don’t use it, but they will not receive the funds tax-free. Though qualified withdrawals are tax-free during your lifetime, the amount that passes to your beneficiaries is fully taxable in the year that you die.
To avoid a large tax burden for your beneficiaries, monitor your financial and health situation on an ongoing basis. Always work with your financial professionals to take full advantage of the tax breaks and opportunities the government provides.