Health Saving Account (HSA) can be used as a tax-advantage saving vehicle, similar to IRA, but more! This is one of the pretax saving that gets overlooked by a lot of people, but it’s actually one of the most powerful one. We will go over on how you can utilize HSA to reduce your tax bill, invest the money, as well as optimization strategy on how you can withdraw from it.
A quick recap, HSA is a pretax saving vehicle that let your money grows tax free. Distribution for medical-related expense is tax free. For non-medical expense, there is a 20% penalty if you withdraw the money before age 65.
The penalty is waived after you turn 65. However, you still have to pay ordinary income tax on non-medical withdrawal. For example, if you contribute $5,000 to an HSA account this year and your marginal tax rate is 25%, you already save $1,250 on your tax bill this year. You don’t have to pay any tax either if you reimburse yourself for healthcare expenses, such as deductibles, copay, prescription, medical supplies (e.g. bandaids), and other medical expense not covered by your insurance. Please refer to IRS publication 502 for the list of qualified medical expenses.
- Money coming in: Pre-tax
- Growth: Tax free
- Money coming out:
- Tax free for medical related expenses
- Ordinary income tax after age 65 for non-medical withdrawal
- +20% penalty if you withdraw prior to age 65
Just like any other tax-deferred investment vehicle, the power of HSA is in the tax-free growth during your wealth accumulation phase. But wait, we’re doing lifehack for early retirement here, there’s more to it that this!
How to leverage HSA as retirement account
HSA had been referred as Super IRA, IRA on steroid, and The Ultimate Retirement Account. I’ll let you put your own monikers after you read this article. Here’s how you can optimize this awesome saving vehicle.
You want to max out your HSA contribution each year. As of 2018, the maximum contribution is $3,450 for single coverage, $6,900 for family coverage. Supposed you are in the 25% marginal tax bracket, you save $1,725 each year on your tax bill on annual $6,900 contribution.
Additionally, if you contribute through payroll deduction, you’ll save another 7.65% FICA taxes, which is an additional $527.85 money stays in your pocket.
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In our case, our plan allows us to keep $500 minimum balance in the HSA checking account and invest the rest of the money. You want to put this money in a low cost index fund automatic investment. Set it once, then forget it.
This is something that I just find out recently that you can reimburse yourself the medical expenses that you pay out of your pocket (after tax) at any time. There is no time limit on when you can reimburse yourself.
Here’s an article from the IRS website to illustrate the point.
“Q-39. When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?
A-39. An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year. See Notice 2004-2, Q&A 31 and also Notice 2004-25, for transition relief in calendar year 2004 for reimbursement of medical expenses incurred before opening an HSA.
Example. An eligible individual contributes $1,000 to an HSA in 2004. On December 1, 2004, the individual incurs a $1,500 qualified medical expense and has a balance in his HSA of $1,025. On January 3, 2005, the individual contributes another $1,000 to the HSA, bringing the balance in the HSA to $2,025. In June, 2005, the individual receives a distribution of $1,500 to reimburse him for the $1,500 medical expense incurred in 2004. The individual can show that the $1,500 HSA distribution in 2005 is a reimbursement for a qualified medical expense that has not been previously paid or otherwise reimbursed and has not been taken as an itemized deduction. The distribution is excludable from the account beneficiary’s gross income.”
For practical purposes, my plan is to only defer the HSA distribution on health care bills > $100 (i.e. keep receipts for any health care bills above $100). For smaller bills, I’ll go ahead and reimburse myself that year so that I don’t end up with too many small-bill receipts. Check out the illustration in this article to compare money grows in pre-tax vs. post-tax environment. The idea here is to shield the growth from tax along the way.
I will definitely scan this receipt and save it in the cloud (e.g. Google Drive, iCloud) to track them in a spreadsheet to ensure I have multiple records.
On early retirement (before age 65), I can start use the receipts I saved above to reimburse myself like an ATM from Aloha Jim’s bank. I can then use the remaining of HSA balance to pay for health-related expenses, tax free.
Lastly, once I turn 65, I can treat this HSA account like a traditional IRA. I can withdraw the money for non-health-related expenses, penalty-free (I’ll still have to pay for ordinary income tax, but this should be smaller than today).
Retire By’s take on HSA
HSA is an incredibly powerful investment vehicle for retirement purposes, especially when you are young and reasonably healthy (i.e. don’t have a lot of health-related expenses). When invested over a long period of time, it will grow significantly, shielded from tax. At retirement, you have several options to withdraw the funds from it.
Here’s an illustration on how $6,900 annual contribution grows over 30 years. It is a peace of mind having this much money to cover your health-related expenses on old age. But it has flexibility along the way to leverage this as a retirement saving account as well. No wonder they call this IRA on steroid!