How To Use A Health Savings Account

Health Savings Accounts, or HSAs, are tax-deferred accounts for individuals or families who are covered under a "high deductible health plan". Like retirement accounts, there are both contribution and distribution rules governing the tax advantages with HSAs.

There are two main use philosophies with HSAs, and in this post I'll give you a framework to follow depending on your specific circumstances. I'll even share one extra secret sauce strategy I employ with my own HSA.

First, The Basics

To qualify for an HSA, you either need to be covered by a high deductible health plan at work or one you purchase on your own out on the open market. As long as the health plan conforms to the following, you're eligible to make HSA contributions.

- Minimum deductible of at least $1,300 ($2,600 for family coverage).

- Out of pocket maximum of no more than $6,550 ($13,100 for family coverage).

Assuming your health plan falls within those guidelines, you (and/or your employer) is eligible to make contributions to the HSA. Here are the 2017 contribution limits.

- $3,400 for individuals.

- $6,750 for families.

Similar to IRAs and Roth IRAs, if you're a seasoned investor over age 50, you get to make additional

catch-up contributions in the amount of $1,000.

Contributions you make (not your employer's contributions) are considered pre-tax. When contributions originate from payroll deductions, then taxable income is reduced, meaning you'll enjoy a lower tax bill. If you're self-employed like me, you make contributions from your bank account but then you receive a deduction based on the amount of the contribution. Same outcome, just a different way to arrive at it.

Once contributions are in, the amount of time those dollars remain in the HSA is irrelevant in the eyes of the IRS. What matters is when dollars come out of the HSA, as long as they are used for "qualified health expenditures", both the original contributions as well as any growth associated with those dollars comes out tax-free. Qualifying for tax free distributions is easy as the definition of "Qualified" is robust. Here is a partial yet impressive list of medical costs that count.

- Physician fees.

- Lab fees.

- Dental fees.

- X-rays.

- Prescription drugs.

- Vision care.

- Physical therapy.

- Chiropractic care.

Some HSAs come with an investment component that allows the account owner to invest cash sitting in the account. More on that in a bit.

Two Use Philosophies

Knowing that you can leave contributions in the HSA for as little as a day or as long as you wish, the fundamental question you must answer before making contributions is will my contribution be used immediately or will it remain in the account to grow for a future use?

Use It Now

This strategy accepts the idea that we're limiting the use of the HSA to the pure benefit of the tax deduction.

Using It Now works best for folks who 1. don't have much spare cash laying around 2. need to play catch up in their retirement account contributions 3. don't believe they'll incur future medical expenses 4. don't want to bother managing another long term account for a specific future expense.

This type of HSA user typically contributes an amount equal to annual qualifying medical expenses (within the contribution limits, of course!).

Use It Later

By delaying HSA distributions until a future date, you're setting yourself up for a tax-deferred growth opportunity. It's the equivalent of saving in a Roth IRA versus a taxable investment account. The "after-tax" return of the Roth IRA is typically greater than the "after-tax" return on the same money in a taxable investment account.

Several HSA providers allow the account owner to invest their contributions in mutual funds, which in my opinion is a prerequisite for the Use It Later tactic. If the investment time frame is long and the capacity for risk is relatively high, it's acceptable to leverage any of the growth oriented funds offered within the HSA.

The Use It Later philosophy works best for investors that 1. can pay for annual medical expenses out of current cash flow 2. are on track with retirement and college education savings 3. believe that someday they'll be old and decrepit which equates with a high amount of future dollars spent on healthcare. This type of HSA user typically maxes out contributions to the plan.

My Secret Sauce HSA Tactic

There's a common misconception promoted by HSA issuers that touts the ability to pay for medical expenses directly from the HSA. While I consider this a simplicity benefit, it's not the most efficient way to realize a full monetary benefit. There's no rule that forces us to pay for qualified medical expenses directly from the HSA. Therefore, why not put the medical expenses on a credit card to earn those coveted reward points? You think the HSA is going to give you 2% cash back on purchases? The answer is no.

Paying for qualifying medical expenses from a rewards card delivers the dual benefits of higher credit card points accrual as well as the tax deduction on contributions for your medical expenses!

How I Execute The Accounting & Contributions In My HSA

As soon as I incur a qualifying medical expense, I update my spreadsheet and save the receipt in a special folder in Apple's iCloud where my personal documents are organized. Here's what my current spreadsheet looks like (note the $0 spent on Pregnancy Test Kit, that's proper planning!).

If you follow the Use It Now philosophy like I currently do, wait until the end of the year to tally up your total medical expenses. Prior to tax filing, I make a single contribution matching the total in my spreadsheet. Then, I immediately pull the cash back out and put it back into my Checking Account Which Earns 1%. In February of the following year, I receive a tax form showing the distribution. Since my distribution always matches my medical expenses (and contribution amount) I never pay tax or a penalty. I prefer to execute my contribution and distribution the week between Christmas and New Years just to keep it clean from a calendar perspective.

The Best HSAs

Recently, Morningstar conducted a study of the 10 largest HSA providers. They were ranked according to which functioned best as a spending vehicle (correlated with the Use It Now philosophy) as well as the best ones to use as an investment vehicle (the Use It Later philosophy).

Source: 2017 Health Savings Account Landscape, Morningstar.

Depending on which use category you best fall into, view the rankings as a guide for where to set up your HSA. If you already have an HSA associated with your employer and it didn't make either list, there's no reason why you can't open up your own HSA outside of your employer. The tax benefits are the same no matter where the contributions originate from.

Consider ditching your employer's HSA and opening your own if you meet the following three criteria:

- Your health insurance plan conforms to the definition of "high deductible".

- Your employer does not contribute to your employer sponsored HSA.

- Your current HSA is expensive as well as a pain in the ass.

Wrapping It Up

HSAs can be a great tool to take advantage of if you qualify. They are considered triple tax free; you receive a tax deduction based on contributions, interest, dividends, and capital gains within the HSA are all tax-deferred, and all distributions for qualifying medical expenses (at any age) come out tax free.

Determining eligibility and whether or not to use your employer-sponsored HSA can get complicated beyond the factors identified in this post. If you're unsure, use the contact form below to introduce yourself so we can point you in the right direction.

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