What is an HSA and should I use it?

Happy Tuesday!

I received another great reader question that couldn’t be more timely. With a lot of open enrollments going on right now (Healthcare.gov just opened over the weekend), the reader asked about using a Health Savings Account (HSA) as a long-term investment tool.

Today I’ll explain what these accounts are and how you can take advantage of one if you have the option.

What is an HSA?

A HSA combines the features of a tax-advantaged savings account with a high-deductible insurance plan.  The contributions are tax-deductible and withdrawals used to pay qualified medical expenses are tax-free.   Qualified medical expenses can include your deductible, co-payments for doctor’s visits and prescriptions, as well as dental and eye care.

You can also reimburse yourself for the money that Social Security withholds from your benefits to pay for Medicare Part B, Part D or Medicare Advantage (but not medi­gap) premiums, or for a portion of your long-term-care insurance premiums.

For 2014, a high-deductible plan requires a minimum deductible of $1,250 for an individual and $2,500 for a family.  You can make pretax or tax-deductible contributions in your account up to $3,300 a year if you have individual coverage or $6,550 a year for family coverage.  Those age 55 and older can save an additional $1,000 per year.

Benefits of HSAs

Given the amount that can be contributed in these accounts, the tax savings can be several hundreds or even thousands of dollars. For example if you’re a family in Illinois (5% state income tax) that is in the 28% marginal federal tax bracket, and you fully fund your HSA, you save $2,162 in income tax. Not only do you save in taxes, most high deductible plans also offer lower premiums

Unlike a flexible spending account, you don’t have to use the money by the end of the year; it can grow tax-deferred in your account for later use.

Drawbacks of HSAs

Even though these accounts have many benefits, they do have some drawbacks, especially if you don’t use them wisely

You have to pay ordinary income tax plus a 20% penalty if you use the funds for non-medical expenses and are below age 65. In addition, the investment options for your account may be limited to a low-interest savings account or a few mutual funds depending on how much money you have invested. The limited options make sense since you want the money liquid to pay for medical bills that may arise in the near future.

Final Answer

So to answer the reader’s question, I love HSAs for people who have can use the money for qualified medical expenses. The accounts can also play a significant roll in diversifying your investment portfolio to guard against higher medical expenses when you’re older.

However, I wouldn’t use them primarily as a long-term investing vehicle because of the limited investment options and the fact that you may need the money for medical expenses in the short term. Continually using the funds in the account each year won’t allow for much compound growth. You can find a lot more efficient and low-costs investment for your future by using a traditional or Roth IRA.

Lastly, you don’t necessarily have to choose between the two. You can estimate your family’s medical expenses for the year if you’re keeping a budget and put that amount in the HSA.  Then use the rest of your disposable income to invest for retirement. If you have enough to max out both, I say go for it!