The Health Savings Account (HSA) is one of the most underrated and misunderstood tax optimization tools offered to young professionals. This article explains the basics and how to unlock the full power of this hidden tax-efficient treasure.
Introduction to the Tax Avoidance Spectrum
Consider the world of tax avoidance (or evasion) on a spectrum.
On one side, you’ve got the All-American, bread and butter strategies. These are your 401Ks, Roth IRAs, Roth 401Ks, etc. We’ve talked about these powerful strategies at length in separate posts. They receive lavish praise from mainstream financial pundits and advisors. Most people who reach a moderate level of financial literacy recognize the importance of such accounts.
On the other edge of this spectrum, you’ve got what I’ll call the “Bond villain” book of tax avoidance tactics. This might include building complex webs of shell companies in discrete foreign nations, laundering money through semi-legitimate small businesses, or bribing corrupt officials. You get the idea. Some sexy clandestine stuff. At a minimum, these activities are amoral. Most often, they’re also illegal.
Mapping the Health Savings Account on the Spectrum
The Health Savings Account (HSA) sits someplace between the two limits of the tax avoidance spectrum. It carries Bond-worthy sex appeal (without the risk of imprisonment or death).
Implemented effectively, the HSA allows individuals to reduce their current tax liability and grow gains tax-free like a traditional 401K. Incredibly, if that individual follows a few more instructions carefully, the IRS also allows tax-free withdrawals of HSA funds any time! Remember that in contrast, a traditional 401K doesn’t allow penalty-free withdrawals until the age 59.5. And when these withdrawals occur, they are taxed based on an individual’s tax bracket at this older age.
Hopefully the incredible value and flexibility that an HSA provides is beginning to sink in. It offers a lethal combination of three tax benefits rolled into a single account. There is a realistic path to you never paying taxes on the money that you contribute. To summarize:
- Money contributed to an HSA reduces your tax bill today
- The funds grow tax free while held in the HSA
- Withdrawals from the account are then distributed completely tax-free (assuming you play the game the right way). More on that below
Poof. We just legally evaded taxes. Let’s dig into the details around how to put this theory into practice.
Health Savings Account Basics
As you might imagine, the government requires people to jump through a few hoops before granting access to such a powerful tool. After all, the IRS doesn’t want to allow everyone to avoid hundreds of thousands of dollars in taxes.
The government, therefore, only grants access to HSAs for people who enroll in a specific type of insurance called a High Deductible Health Plan (HDHP). Before diving into an overview of the HSA, let’s briefly set the stage by explaining this insurance eligibility requirement.
High Deductible Health Plans (HDHPs)
Under an HDHP, policyholders agree to pay higher “deductibles” in exchange for lower monthly premium payments. Think of a deductible as the total medical expenses that an individual must incur prior to insurance covering the bill.
This means a higher deductible could potentially expose policyholders to an increased financial burden. In situations that require a high level of medical care, the patient pays a higher share of the medical expense. Recall, however, that the HDHP also includes the benefit of lower monthly premium payments. And policyholders must pay premiums no matter what. Whether the HDHP enrollee uses health insurance daily or once yearly, the monthly premium remains constant.
As a result of this dynamic, HDHPs provide compelling value to young, healthy professionals. This demographic is less likely to need the robust level of health coverage that older generations might prefer (at the expense of higher monthly premiums).
Since an HDHP also grants policyholders HSA eligibility, the decision to enroll in one of these plans could equate to an exponential increase in net worth over a lifetime.
Health Savings Account Facts
All of this might sound a bit too good to be true. It’s not, but few people out there know how to leverage full the power of an HSA to receive maximum benefits.
Recognize that the government originally created these accounts to stimulate saving among the HDHP population. They wanted to mitigate the financial distress that these policyholders faced when confronted with true medical crises.
In the process of building this incentive system around the HSA, legislators created some incredible loopholes in the tax code. The savviest investors took immediate notice. And they continue to exploit these loopholes every year to get richer. Let’s see how we can do the same.
5 Steps to Creating Next-Level Wealth with an HSA
1) Enroll in a High Deductible Health Plan
If you work in a traditional corporate job, the first step is to confirm the terms of your current insurance plan.
You might already be enrolled in a high deductible plan without even knowing it. In this case, you could start funding an HSA immediately.
If you’re not currently enrolled in an HDHP, review your firm’s benefits package with the HR team. They can provide additional insight about the full suite of your company’s coverage options which likely includes an HDHP. To switch from your current plan to an HDHP, you’ll probably have to wait for your employer’s annual “open enrollment” period, during which time plan changes are permitted.
Note that individuals who purchase insurance on the federal government’s exchange can also enroll in an HDHP through a similar process.
2) Max Out Your Health Savings Account Contributions
Individuals may contribute a maximum of $3,600 to their HSA’s in 2021. For families, the contribution limit is doubled to $7,200. Strive to hit these maximum limits.
There are two primary ways to fund an HSA.
The first option is for employees to fund it directly through payroll contributions. This method functions similarly to 401K contributions. The funds are transferred into the HSA with “pre-tax” dollars, reducing an accountholder’s gross annual income. This is my preferred option because it offers the least friction and puts my HSA funding plan on autopilot.
An alternate option is for individuals to fund an HSA with money held in a separate account. The process functions similarly to a regular bank transfer. You can then deduct the aggregate amount of funds contributed over the year on your annual tax forms. This method may prove useful for those switching jobs towards the end of the year or working in an entrepreneurial capacity.
3) Invest the Health Savings Account Funds
Your HSA provider will dictate the investment options and terms offered as part of your plan. Many providers require a minimum balance of a couple thousand dollars before funds become eligible for investment. This reality may delay your transition to step three for a few months. Stay patient.
Once eligible, review the investment funds listed on your provider’s menu of choices. Refer back to our advice in Level 2 of the financial game. Choosing how to invest your HSA funds is quite similar to the process of investing your 401K. You’ll seek the lowest-fee (AKA “expense ratio”) option that provides the highest level of diversification. This will typically take the form of an index fund that tracks a broad basket of stocks.
4) Double Your Emergency Fund
Hopefully, if you’re dabbling in the more advance realm of HSA tax optimization, you’ve already built your 3-6 month emergency fund. Now, time to double it.
This step may seem random. However, it’s crucial if you hope to squeeze the maximum level of benefits out of an HSA. Why?
The idea is to avoid using the HSA in the way it was originally designed (to pay for out-of-pocket medical expenses throughout the year). Instead, your goal is to transform the HSA into a triple-tax advantaged weapon of an investment account. This requires keeping your HSA funds invested for as long as possible. While it takes some discipline and advanced planning, the exponential return on your net worth makes the effort worthwhile.
A hefty emergency fund supports this mission. Building significant cash reserves will allow you to cover occasional out-of-pocket expenses in full. This keeps your HSA funds in place, growing and working for you, in the most tax-efficient way possible. This will generate incredible tax savings for you over the course of your life. And while the government didn’t necessarily intend for people to repurpose the HSA in this way, it’s entirely legal.
5) Save Receipts & Repeat
Up to this point, we’ve established that the HSA is an incredible tool. You know you should contribute the maximum, invest the funds, and let them grow for as long as possible.
But how do you ultimately access these funds? After all, to avoid taxation on withdrawals, the funds must be used for qualified medical expenses. If you fund an HSA for decades, and it grows into a significant chunk of your net worth, it may feel unsettling to have these funds restricted to medical expenses.
Here’s where the biggest IRS loophole of all comes into play. The IRS doesn’t place any timeline parameters around tax-free HSA reimbursement. If you won’t take my word for it, check out IRS Notice 2005-40 (Q-39).
This is incredible news! It means the $8K out-of-pocket expense you paid towards surgery at 28 can be withdrawn when you’re 48 (or any age). Completely tax-free. The only catch is that it requires a bit of organization as you must keep a record of these payments. But technological advancements are making this organizational process more seamless by the day.
Do you see the power of this? Money spent on out-of-pocket medical bills today can be transformed into “fun” money later in life. Additionally, as personal health expenses grow in your elderly years, maintaining a surplus of funds in your HSA will serve as a valuable security blanket.
There’s one final twist. After the age of 65, you can withdraw HSA funds for any reason without penalty. While you’ll pay income taxes on these withdrawals just like you would for traditional IRA distributions, it’s comforting to know that you can access these funds easily in retirement. So in the rare event that you manage to avoid any major medical expenses throughout your life, the HSA still has you covered.
Health Savings Account Key Takeaways
Once you’ve checked off the basics on your path to building bulletproof wealth, the HSA presents a perfect opportunity to level up one step further. Even if you decide against “hacking” your HSA, into the uber tax-efficient investment vehicle we’ve discussed here, it still provides great value. Automating your savings process by automatically deducting HSA contributions from your paycheck will build momentum and discipline.
But for the true tax optimization enthusiasts, there is perhaps no greater (legal) tax avoidance strategy than the five-step HSA plan presented above. Employing this strategy will allow you to enjoy incredible tax savings and financial flexibility.
It might not be quite as sexy as that Bond villain’s interconnected web of shell companies in the Cayman Islands. But if you follow the five-step plan, that ACL surgery today might very well pay for your trip to the Caymans at some point in the future. Close enough!