How do you make the most of an HSA?

Jack G. says, “Hi, Laura. I recently enjoyed your finance podcasts on HSAs–thank you! I heard about a unique HSA feature allowing me to buy qualified items, save receipts, and reimburse myself later, potentially growing my HSA dollars tax-free. Could you confirm or elaborate on this?”

Jack, thank you for the great question! I’m sure other Money Girl listeners and readers would like to know more about optimizing a health savings account or HSA. I’ll answer your question, review which health plans qualify for an HSA, and discuss strategies to maximize their terrific tax benefits.

What is a health savings account (HSA)?

HSAs were created in 2003 to help Americans manage and reduce the rising costs of healthcare. They are my all-time favorite tax-advantaged accounts because they allow you to cut medical costs, eliminate taxes, and invest your balance for growth. Many financial experts call it a “triple tax threat” because HSAs provide three significant tax advantages:

Your HSA contributions are never taxed.

An HSA gets funded with pre-tax dollars, whether you or someone else, like an employer or family member, makes them on your behalf. The money you put in the account is tax-deductible, reducing your taxable income, even if you don’t itemize deductions on your tax return.

You can make HSA contributions any time, even up to April 15 for the previous tax year–but you’re never required to make them. You can contribute even if you’re retired, unemployed, or have an annual income less than your contributions. However, once you enroll in Medicare or get claimed as someone’s tax dependent, you can’t make HSA contributions.

Your HSA earnings are never taxed.

Similar to bank savings, most HSAs pay interest. In addition, you can typically choose from a menu of investment options, similar to a retirement account. For instance, you can transfer all or a portion of your HSA to various mutual funds or exchange-traded funds (ETFs) to grow your balance.

But unlike a taxable bank or brokerage account, you don’t pay income taxes on interest or investment growth on HSA funds.

Your HSA withdrawals are never taxed.

When you take money from an HSA to pay qualified healthcare expenses–including medical, dental, hearing, and vision care costs–your contributions and account earnings are entirely tax-free. That’s even better than a traditional retirement account, where you must pay income taxes on withdrawals.

So, the triple tax advantage of an HSA means your contributions, earnings, and withdrawals for qualified healthcare expenses are tax-free. That’s pretty sweet!

Listen also to episode 800 of Money Girl below. Laura helps you understand the unique benefits of an HSA and rule changes for 2024.

Which health plans qualify for an HSA?

While the HSA benefits are excellent, not everyone can cash in. To qualify for an HSA, you must be enrolled in a qualifying high-deductible health plan (HDHP). As the name indicates, an HDHP has a relatively higher annual deductible, which means you pay a lower monthly premium.

Most HSA-eligible health plans cover specific preventive care at no charge, such as annual physicals, prenatal and well-child care, immunizations, and screenings, regardless of the deductible. That means many medical costs are covered, even if you don’t meet your annual deductible.

Knowing if your HDHP is HSA-qualified gets tricky because not all health plans with high deductibles are eligible. By law, HSA-eligible plans must have a minimum deductible and a maximum out-of-pocket cost for individuals and families.

For 2023, HSA-eligible health plans must have:

An annual deductible higher than $1,500 for individuals and $3,000 for family plans.
An annual out-of-pocket maximum of $7,500 for individuals and $15,000 for family plans.
Benefits that only begin after the deductible is met, except for preventive care services, such as getting physical exams, cancer screenings, and immunizations.

A health policy should specify in its name or description if it meets those criteria and is HSA-eligible. Then, you can open an HSA, fund it, and use it to pay qualified healthcare costs tax-free.

Also, understand any HSA changes in 2024.

What are the downsides of an HSA?

To know if paying a higher annual deductible for an HSA-qualified health plan is worth it, know the account’s pros and cons. I reviewed the unique, triple tax advantages you get with an HSA.

The main downside is that spending an HSA on non-qualified expenses, such as rent or a vacation, is against the rules. If so, you must pay income tax plus a hefty 20% penalty on non-qualified withdrawals. So, never put money into an HSA that you might need for everyday expenses.

Also, note that an HDHP isn’t for everyone. For instance, if you have a chronic illness, take expensive prescription medications, or have children, you could pay more than for other health plans with lower deductibles.

However, if you’re relatively healthy and don’t expect high medical expenses, you may be better off having an HDHP in combination with an HSA. Remember that health insurance wasn’t designed to cover every possible medical expense but to protect your finances against devastating accidents and expensive illnesses.

What happens if you no longer qualify for an HSA?

A common question is what happens to an HSA if you become uninsured or switch to a non-qualified health plan. The good news is that you can still spend your HSA on qualified expenses tax-free. However, you can’t make new HSA contributions if you’re not covered by a qualified health plan.

An often-overlooked HSA benefit is that if you still have funds in one after age 65, it becomes similar to a retirement account. You can use it for non-medical expenses without the steep 20% penalty; however, you must pay income tax on non-qualified withdrawals. That’s a great reason to max out an HSA yearly, even if you don’t expect many medical expenses.

How much can you contribute to an HSA?

While there’s no requirement for HSA participants to make contributions, annual caps do exist. For 2023, you can contribute up to $3,850 if you have insurance for yourself or up to $7,750 for a family plan. For 2024, those limits will increase to $4,150 and $8,300. Plus, if you’re over age 55, you can contribute an additional $1,000.

Some employers offer HSA matching, which gets included in those annual limits. But note that whether you get HSA-qualified insurance on your own or through an employer, you can take it with you if you leave an employer, change your health plans, or retire.

A great HSA feature is that there’s no spending deadline. If you don’t have any medical expenses or don’t want to use HSA funds to pay for them, your balance rolls over from year to year, even if you no longer have an HSA-eligible plan. You can always spend it on qualified, out-of-pocket healthcare costs for you, a spouse, or your dependents.

Should you spend or invest HSA funds?

Now, let’s return to Jack’s question and discuss different strategies for using an HSA. Since HSA rules don’t require you to spend your balance or immediately reimburse yourself for qualified medical expenses, you can opt not to make withdrawals.

For instance, you can keep your HSA balance invested and use your personal funds to pay healthcare costs. That way, as Jack mentioned, you’d have more HSA money growing tax-free. If you’re relatively young, maxing out an HSA annually and allowing it to grow for decades could be more valuable than spending it tax-free on healthcare.

Another option is what Jack asked, which is allowing your HSA to grow and reimbursing yourself for qualified expenses sometime in the future. That strategy is allowed and known as “shoeboxing” your HSA.

On the one hand, spending your HSA on immediate healthcare needs gives you guaranteed tax savings, which could be 30% or more, depending on your income and average tax rate. On the other hand, letting your HSA stay invested at a good return for decades could yield more, depending on your average return and how long the funds stay invested.

Note that shoeboxing requires you to keep good records to verify qualified healthcare expenses and create an accurate IOU for yourself. You can redeem it anytime by making an HSA withdrawal to reimburse yourself for multiple expenses. You could write yourself a check or initiate a bank transfer from your HSA as needed, even decades in the future.

Be sure you know how your reimbursed healthcare expenses were paid initially and that you didn’t claim them as itemized medical deduction on your taxes, because you can’t do both. Also, note that you can’t use HSA funds to pay expenses that occurred before you opened the account or were reimbursed by your health insurer or employer.

How do you open and fund an HSA?

If you qualify for an HSA, they’re available at many banks, credit unions, brokerages, and specialty institutions. A couple of my favorites are Lively and HSA Bank. They’re convenient and offer paper checks, debit cards, and online banking. Shop around for an HSA that offers diversified investment options, low fees, and a convenient online experience.

This article originally appeared on QuickandDirtyTips.com and was syndicated by MediaFeed.org.