When It Pays to Max Out Your HSA

HSA Debit Card

A Health Savings Account (HSA) is a unique tool that provides special tax benefits when used for medical expenses. They are packaged as an add-on to a high deductible health plan and are becoming an increasingly popular employee benefit. We field lots of questions on these accounts – everything from how they work to whether its better to fund an HSA or a 401(k). Everyone is different but there are a few general guidelines to know as you think through what’s best.

Taxes and HSAs

Start with the basics. Money deposited into an HSA goes in before any federal income taxes are paid. The earnings on all money inside the HSA also get a pass on income tax at the Federal level, which makes this account similar to an IRA or a 401k. The difference is in how money comes out of an HSA – the distributions are income tax free if you use it for qualifying medical expenses. This “triple tax” advantage (going in, growing, and coming out) makes it a great deal when used for its intended purpose.

But there are some caveats to be aware of before going all in. First and foremost, the deposits into an HSA are income tax free at the federal level but not necessarily the state level. California and New Jersey fully tax all contributions as well as dividends and interest in an HSA. New Hampshire and Tennessee do not have a state income tax and therefore do not tax contributions made to an HSA, but they do tax the dividends and interest earned. Ouch!

Here’s where it gets really confusing: FICA taxes could be owed under certain circumstance. These are the taxes that are used to fund social security and Medicare. Any contribution your employer makes to your HSA is made free and clear of any FICA taxes. Woo-hoo! However, your contributions are only FICA tax-free if they are made as part of salary reduction arrangement in a section 125 cafeteria plan. This is because those aren’t considered wages and therefore aren’t subject to FICA in the first place. But if your contribution is made through a payroll deduction plan then it will be subject to FICA.

Not sure if your money is going in as part of a section 125 cafeteria plan? Check with HR. Any HSA contributions made by your employer or you through a section 125 plan will show up on your W2 in box 12 with a “W” code.

How to Use an HSA

Money from an HSA needs to be spent on qualified medical expenses. These are broad but cover things like deductibles, co-insurance, prescription drugs, dental fees, eyeglasses, lab fees, and orthodontia. Other medical expenses like elective cosmetic procedures, teeth whitening, over-the-counter prescriptions, and toiletries don’t qualify. The full breakdown can be found in Publication 969 – Health Savings Accounts and Other Tax-Favored Health Plans.

Notably, health insurance premiums cannot be paid from an HSA. That is a big no-no. The distribution will be subject to ordinary income taxes and a 20% penalty if the money is spent on an unqualified expense like insurance premiums.

With all that being said, HSAs are still a wonderful place to save money. The maximum contribution in 2021 is $3,600 for an individual / $7,200 for a family. There is a catch-up contribution of an extra $1,000 if you’re over age 55. These aren’t huge dollar values but regular contributions and potentially decades of compounding can add to big numbers down the road.

Don’t let the tax tail wag the dog. HSAs offer attractive tax benefits but are only available on high-deductible health plans (HDHP). The tax savings offered aren’t enough to offset a year with heavy medical expenses. Think carefully if you hit your annual out-of-pocket maximum on a somewhat regular basis.

What to Fund First

Starting up an HSA is generally a good idea if you elect the High Deductible Health Plan. Maxing it out is best but cash flow may not always allow for that. This is the framework we use when evaluating where to allocate a limited amount of dollars:

Capture any and all employer money offered. This is free money and low hanging fruit. Look to retirement accounts first and contribute enough to receive the full employer match. Contribute enough to capture any employer match in an HSA after capturing the match in your retirement account.

Why do it this way? You can always pay for medical expenses from your retirement accounts, but you can never pay for your day-to-day living expenses penalty free from an HSA. Moreover, you can itemize and deduct your medical expenses if they exceed 7.5% of your Adjusted Gross Income (AGI) for the year. You can still get a tax break for medical purposes when paying from retirement accounts if you have a terrible, no good, incredibly bad year. When dollars are limited and you can’t do it all, think of your retirement accounts as the meat and potatoes and the HSA as the gravy.

But what if the match is only offered in your HSA? Then flip the order of operations. Go where the *free* money is flowing but be sure to fill your cup from the retirement tap first if both taps are flowing. Use your future pay raises to fund your retirement accounts if there is only enough to fund your HSA.

When to Use an HSA

There is a school of thought around deferring the use of your HSA to retirement. We’re generally for this. Paying for medical expenses out of pocket allows your HSA to compound tax-free for what could be decades. The low dollar contribution limits mean that its difficult to grow these accounts to meaningful levels in the first place. But deferring its use may allow you to build up a six-figure sum in your HSA by the time you do finally enroll in Medicare. This is a huge anxiety-reliever given the high price tag and uncertainty of healthcare expenses in your golden years.

There’s another planning technique worth mentioning with an HSA. You can contribute money to these accounts until you enroll in Medicare. The triple tax advantage of these accounts makes them superior to retirement accounts when used for medical expenses. Current law allows you to make a once in a lifetime rollover contribution from your IRA to an HSA so long as you’re still eligible to contribute to an HSA (i.e. not yet enrolled in Medicare and in the HDHP). The maximum rollover amount is capped at the same level as your annual contribution, or $3,600 for an individual and $7,200 for a family. Additionally, you need to stay in the high deductible health plan for at least 12 months following the transfer. Failure to do this results in a 10% penalty and ordinary income taxes on the amount of the transfer.

You have the option to roll money from a traditional IRA or a Roth IRA, but it’s generally not advisable to roll money from the Roth. This is because distributions from your Roth IRA are already income-tax free regardless of the expense! Rolling it to an HSA essentially slaps a narrow spending restriction on those funds as well as a possible 20% penalty. That is no bueno.

Parting Thoughts

Lastly, consider how these HSAs are treated when you pass away. Your spouse can takeover your HSA when you die without any difficulty. Your kids won’t get that same kind of deal. HSAs turn into regular taxable accounts when they’re left to a non-spouse beneficiary. The obvious takeaway is to name your spouse as the sole primary beneficiary!

There is also no step up in basis on these accounts nor are there any stretch provisions like there are for retirement accounts. The tax implications are poor for any non-spouse who takes over one of these accounts. Ultimately, HSAs are great tools while you’re living but make for poor assets to leave to the next generation. Drain it during your lifetime!


The information contained herein is intended to be used for educational purposes only and is not exhaustive. Diversification and/or any strategy that may be discussed does not guarantee against investment losses but is intended to help manage risks and return. If applicable, historical discussions and/or opinions are not predictive of future events. The content is presented in good faith and has been drawn from sources believed to be reliable. The content is not intended to be legal, tax, or financial advice. Please consult a legal, tax, or financial professional for information specific to your individual situation.

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