Tips for increasing the benefits and tax breaks of HSAs

Tips for using a 'medical IRA' that offers triple the tax savings

December 7, 2023 9:17 PM

Healthcare in America, especially for older clients who live increasingly longer lives, is frighteningly expensive and seems to get more so every year.

Enter the health savings account, a tax-advantaged vehicle that can help many working Americans better plan for their medical and financial futures. It's a savings and investing account that Americans are becoming more aware of, but often still fail to make full use of, advisors say.

"The HSA offers the unique advantage of being a triple-tax-free account, providing valuable tax benefits that can enhance the overall effectiveness of a retirement strategy," said Ashley Folkes, the founder and managing partner of hybrid RIA Inspired Wealth Solutions in Hoover, Alabama.

The HSA, which an individual can contribute to if they're enrolled in a high-deductible health plan, among other criteria, can be used prior to age 65 to pay for qualified medical expenses such as doctor visits, dental treatment, vision services and prescription drugs, as well as a host of other health-related expenses. It also packs a punch as an investing vehicle for retirement because it trumps several other well-known retirement accounts, like the 401(k) and Roth IRA, for its tax-saving perks.

First, HSAs can help clients get an initial tax break by lowering their pretax income when they contribute. Second, the accounts can grow tax free. Third, clients can take withdrawals tax-free for "medical expenses later in life, when healthcare is expected to make up a larger portion of overall household spending," according to David Tenerelli, a financial planner at Strategic Financial Planning, a fee-only RIA in Plano, Texas.

"When their cash flow allows for it, we encourage clients to treat their HSA as a long-term investment account — a 'medical IRA' — and to pay for current medical expenses out of cash flow," Tenerelli said.

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But the problem is that "relatively speaking, if you compare it to other types of accounts, the contribution limits are relatively low," Ben Storey, senior retirement products manager in the Retirement and Personal Wealth Solutions group at Bank of America, said in an interview. "That creates less of a focus due to those lower limits. And especially when you look at high net worth clients, this may be a small percentage of their overall net worth."

Currently the maximum allowed HSA contribution in 2023 is $3,850 for individual coverage and $7,750 for family coverage, with the opportunity for an additional catch-up contribution of $1,000 if the account holder is aged 55 and older. The deadline to contribute for 2023 is April 15, 2024, so clients still have time. In 2024, that limit will grow to $4,150 for individuals and $8,300 for families, with the same catch-up allowance.

Legislation pending in Congress could roughly double the limit of what's currently allowed for contributions, making them a somewhat better deal.

Storey said Bank of America's 2023 workplace benefits report found that a majority (73%) of surveyed American employees are contributing to HSAs, and 83% of employers contribute to their employees' HSAs.

"This is certainly increasing," he said. "However, with that being said, they're not necessarily maximizing the potential benefits."

A majority of employees (64%) were making regular withdrawals from those accounts, he said.

"Really what they're doing is, they're limiting that long-term growth potential for their savings …. One of the issues is really the fact that the individuals look at this as more of a spending account versus a savings account."

Financial Planning spoke with experts from across the industry and compiled tips on what financial advisors should know about working with clients on HSAs.

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Factor HSAs into employee benefits

Advisors should periodically review employee benefits their clients are enrolled in and discuss how HSAs fit into those, Storey said.

"Asking those questions: does your company offer a 401(k)? Are you able to do a Roth 401(k)? What about benefits around disability? Life insurance? Do they offer an HSA plan as part of the high-deductible plan? Also, what about retiree health care, pensions?" he said.

Each year when enrollments are open again, or if a client changes jobs, advisors can review those options with clients to see if there is an HSA they may want to enroll in to maximize their benefits.

"Choosing between an HSA through an employer's health insurance plan and opening an individual HSA involves trade-offs," said Ashton Lawrence, director and senior wealth advisor at Mariner Wealth Advisors, an RIA in Greenville, South Carolina.

The employer's plan that comes with an HSA may offer a match, for instance, but that may be offset by unfavorable coverage, premiums or deductible costs in the insurance plan in question.

"While an employer-sponsored HSA may offer the convenience of direct paycheck deductions and potential employer contributions, it might have limited investment options," Lawrence said. "On the other hand, an individual HSA provides more flexibility in choosing a provider and investment options, making it suitable for those who want greater control, especially if they view the HSA as part of a long-term retirement strategy."

Consider different HSA options

Often, it makes the most sense to contribute to an HSA via payroll deductions to receive a deduction to federal payroll taxes and reduce income, Tenerelli said.

"However, not all HSAs are created equal. Some charge maintenance fees or investment fees, and many have cash minimums before investment becomes available," he said.

Most employers don't allow participants to choose their HSA provider, he added.

"So it can sometimes make sense to fund an HSA via payroll and then make periodic partial transfers to a more favorable HSA in order to get the best of both worlds."

HSAs vs. FSAs: not the same

Savers can often confuse the similar-sounding FSA — flexible savings account — with the HSA. But they are significantly different.

FSAs are a use-it-or-lose-it workplace-provided benefit account that offers pretax savings for employees, who can use them to pay for many of the same healthcare expenses that HSAs can also fund. Some FSAs allow a limited amount of unused money from one year to roll into the next, and some allow a grace period, but clients can't invest their FSA money and can't withdraw money tax-free from the FSA, among other drawbacks.

Andrew Herzog, a CFP at The Watchman Group, an RIA in Plano, Texas, said clients run the risk of losing unspent funds still in FSAs at the end of the plan year, but that is not the case with an HSA.

"The main drawback to an HSA is its limited use. If you withdraw money for a non-medical reason, then you're penalized and pay taxes, and some people are not prepared to be boxed in like this," he said. However, "no one can avoid medical costs, and that's what the HSA is for. So whether someone uses the HSA this year or in retirement, you'll get your money's worth."

After turning 65, an HSA account holder is able to freely use those funds like an IRA for any expense, and non-medical withdrawals would be "taxable, but not penalized" at that point, according to Justin Rucci, an advisor at Warren Street Wealth Advisors, an RIA in Newport Beach, California.

Consider investing HSA funds

Jeremy Finger, the CEO of Riverbend Wealth Management, an RIA in Myrtle Beach, South Carolina, said he often sees clients failing to use an HSA for its investing potential and ability to grow exponentially through compound interest.

"They don't have the money invested — it is just sitting in a money market," he said.

HSAs, depending on which provider a client has, can offer a range of investing options such as index funds and different asset classes. So a young professional could potentially invest their HSA in assets with high returns, just like in a 401(k), and see those gains grow tax-free to a large sum over multiple decades.

If a client is close to retirement age, they may want to invest more conservatively. But most investors could stand to benefit from parking their savings in something beyond a low-interest money market fund.

"Advisors should guide clients through the high-deductible health plan requirement for HSAs, ensuring they understand the potential challenges associated with the high deductible, especially if they frequently require medical services," Lawrence said. "It's essential for clients to carefully consider their health care needs, risk tolerance and overall financial goals."

The reimbursement trick

Advisors often see clients take continual withdrawals from their HSAs to cover medical expenses. But there's a better way to maximize the HSA and other benefits, Storey said.

HSA holders can use a high-interest savings account, for instance, to pay for medical bills now, allowing HSA balances to grow.

"I'm a huge proponent of having emergency funds. And even if you earmark some of that, or have some additional savings for healthcare, I think it's a wise decision," Storey said.

Another option is to enroll in a limited-purpose FSA account to pay for dental and vision expenses and still get the pretax benefit of that account, allowing the client to leave the HSA untouched.

Then clients can go to the HSA at any point in the future and reimburse themselves for prior medical expenses. By then, ideally, the HSA will be worth more and the withdrawal will affect a smaller portion of the overall HSA balance.

"If you spend $10,000 on surgery, use your credit card to get points. Years later when you need a new roof or want to go on vacation, pull from the HSA," said Thomas "Tommy" Lucas, a financial advisor at Moisand Fitzgerald Tamayo, an RIA in Orlando, Florida.

It's best to have a backup copy of receipts for those future reimbursements.

"Just take a picture and save it under 'healthcare' in your smartphone. Paper receipts may lose ink over time. Use this to make future withdrawals qualified," Finger said.

Estate planning with HSAs in mind

While HSAs work great for the account holder, "they're not the best vehicles to pass on to heirs," Storey said. If a client dies, the HSA can only be passed on to a spouse tax-free, and only if that spouse is named as the primary beneficiary on the HSA. Non-spouse beneficiaries will have to pay taxes on distributions.

Storey added that clients fearing their imminent death and not having a living spouse to transfer the HSA to upon their death can take an early qualified distribution to lower the tax bill.

However, Storey said, "the beneficiary or the estate can request reimbursement for any unclaimed medical expenses that occurred before the account holder died." But those qualified medical expenses must be paid for within one year of the death of the deceased, according to the IRS.

Unless a domestic partner is a dependent from a tax perspective, Storey said, they would not be eligible to have their medical expenses covered by an HSA. The exception "occurs sometimes when an individual's domestic partner becomes their caretaker," he said. So clients who have a domestic partner and would like that partner to benefit from their HSA upon their death, without tax consequences, might want to consider getting married.

"However, if domestic partners are both covered in a family high-deductible health plan and neither one is a dependent of the other individual, they could open separate HSAs and both contribute up to the family maximum," Storey said.

Talk to those next-gen children

Advisors whose clients have children, or advisors with younger clients, should make a point of talking to them about the benefits of HSAs.

"Those are the individuals that may actually benefit the most," Storey said.

This can be a great way to curry favor with heirs, and it can give those younger investors the greatest amount of time for their HSA balances to grow tax-free.

Beware of Medicare penalties

Advisors should also make sure clients are "in compliance with the rules when it comes to Medicare, because once you enroll in Medicare, you can no longer contribute to the HSA," Storey said.

For those who enroll in Medicare after the age of 65, it gets tricky: Medicare provides a six-month retroactive coverage period (but not before the 65th birthday), so they should stop contributing to an HSA six months ahead of enrollment. Advisors can help clients plan ahead to stop contributing to their HSA then.

"You can still invest the money, you can still have the account, you just can't contribute to the account," Storey said.