The Best Way to Save is a Health Savings Account

What is the most tax-efficient way to save money? A good guess would be a Roth IRA. That’s hard to beat, but if you qualify, a Health Savings Account (HSA) is the best way to save money.

What’s an HSA?

It’s a tax-sheltered investment account that can be used to pay for qualified medical expenses.

An HSA merges the best features of pre-tax and Roth IRAs. As with a pre-tax IRA, your contributions to the account are tax-deductible. Similar to a Roth IRA, the money you withdraw is tax-free if used for qualifying medical expenses. Such a deal is hard to find — tax-deductible on the way in, tax-free on the way out.

You can contribute up to $3,550 with an individual health insurance plan and $7,100 for a family plan per year, along with another $1,000 if you’re age 55 or older.

To use an HSA, you must have a qualifying High Deductible Health Plan (HDHP).

What’s that?

A qualifying HDHP is a health insurance plan where the deductible is at least $1,400 for an individual or $2,800 for a family plan. Also, the out of pocket maximum cannot exceed $6,900 for an individual or $13,800 for a family. (These are the 2020 amounts.) If your health insurance does not satisfy these criteria, you’re ineligible for an HSA.

Why is it such a good deal?

1. You can pay for medical expenses with pre-tax funds. You receive a tax deduction when you contribute the funds to the account, the funds grow tax-free, and then you avoid any taxation when you withdraw the funds to pay for qualified medical expenses.
2. Furthermore, unlike a Flexible Spending Account (FSA), you don’t have to spend the money each year. The funds continue to grow tax-free for as long as you maintain the account. So, if you have to choose between an FSA and an HSA — and if you can keep the acronyms straight — an HSA is almost always better.
3. Lastly, some employers contribute to an HSA to incent employees to choose an HDHP plan as they believe it will reduce total medical expenses and save them money overall. That’s more untaxed free money.

What’s the catch?

Not much.

As I said, you need a qualifying HDHP in order to contribute to an HSA. Depending on your medical and financial needs, you may decide that a high deductible medical insurance plan is not suitable for you or, your employer may not offer that option.

And, if you withdraw funds to pay for non-qualifying expenses, you will pay tax on the distribution (just like a pre-tax IRA) and, if you’re under age 65, you’ll also pay a 20% penalty.

As with most IRS gifts, this tax break mostly benefits the wealthy as an HSA is most valuable if you do not spend the contributions each year and instead let them grow tax-free indefinitely. That’s hard to do if you need the funds to pay for your current health care expenses.

If you do spend the money, you still get to pay for your medical expenses with pre-tax funds but you don’t reap the benefit of the investment income growing tax-free over time. And, if your income and tax bracket are low, the tax deduction you receive is not worth as much as it is for a higher income person.

Otherwise, there’s no catch.