We have discovered an incredible strategy for using a Health Savings Account (HSA) to help fund not only your medical expenses but offer tax-free income in retirement.
What is a Health Savings Account?
An HSA is a tax-advantaged saving account for current or future medical expenses. Unlike a Flexible Spending Account (FSA) or Health Reimbursement Arrangement (HRA), you get to carry-forward any additional funds remaining in the account. This is not a “use or lose it” program. It’s more of a savings account (hence the name).
Am I Eligible To Open An HSA?
To be eligible to open an HSA, you must meet the following requirements:
- Have a qualified high-deductible health plan (HDHP). Simply call your insurance company to determine if your plan is an HDHP.
- You must not be covered by another health insurance plan, such as a spouse’s plan, that is not a qualified HDHP.
- Can’t be claimed as a dependent on another person’s tax return
- Can’t be enrolled in Medicare benefits. It’s OK if you are eligible, you just can’t be enrolled.
What Expenses Are Covered?
All qualified medical expenses (QME) as defined by the IRS Section 213(d) are covered for you, your spouse and any dependent children included on your income tax return. Even items not covered by your insurance are covered if they are on the list of QMEs. The IRS has a nice guide on QMEs.
Contribution Limits and Deadlines
The amount you can contribute depends on whether you’re contributing on behalf of yourself or your family. For 2017, the limits are:
- $3,400 for an individual
- $6,750 for a family
If you are 55+, you can contribute an extra $1,000.
Now let’s get to the good stuff – the strategies
A Standard HSA
An HSA offers the only triple tax-free vehicle we know of. Contributions are pre-tax, interest made with money in the account grows tax-free and, as long as it is used for QMEs, it is distributed tax-free. Additional benefits include:
- Pay for QME’s directly with the tax-free funds in the account.
- The account is in your name. You control it.
- The funds in the HSA remain in the account and are still active and valid regardless of changing employers, companies or health coverage. You just won’t be able to contribute more to it until you are eligible again.
A Self-Directed HSA
HSAs follow the same tax laws as IRAs, and as such, can be self-directed. See our previous article Why Do People Think A Self-Directed IRA Is A Good Thing? for details. Self-directing your HSA provides you all the benefits of the HSA (shown above), plus:
- The ability to invest in the same diverse asset classes as you can with a self-directed IRA. We put a comprehensive list of the potential investments together for you in our Investment Options for Self-Directed Retirement Plans
- If you simply open up a standard HSA with a bank, you only make about 0.5% interest- that sucks. Instead, you can operate your HSA just like a self-directed IRA. You set up your LLC and invest the funds to beat the pants off what the bank is willing to pay you.
Note: Keep a portion of the HSA account in liquid investments if you need to pay for QMEs as needed.
A Supercharged HSA
Since the HSA is a triple tax-free vehicle, why wouldn’t you want to maximize its benefits?
Caution. Our supercharge strategy isn’t for everyone. If you need to use the money you set aside in your HSA, this strategy is not for you. If you can pay for your QME’s as you incur them with after-tax funds, this might prove to be an incredible strategy for your retirement.
Here’s how the strategy works:
- Open a self-directed HSA (See section below).
- Pay for all QME’s with after-tax funds, but save receipts for all QMEs from the first day your HSA is opened.
- Do not submit your receipts for reimbursement yet. Let the balance in your HSA grow and compound over time.
- Contribute the maximum amount to your HSA as allowed. Pay for this through your company if possible. This will be a direct expense to your company, therefore reducing your taxable income.
- Since the HSA is self-directed, you can invest it and watch it grow and compound over the years.
How much? Let’s look at a simple example.
You contribute $6,750 each year for a 15-year period and you get a 10% return each year. At the end of the 15 years, you will have:
- Total contribution (and tax deductions) = $101,250
- Tax savings (assuming 30% tax bracket) = $30,375
- Total Value in HSA to be used tax-free = $214,464
This simple example is for 15 years and doesn’t account for increases in the maximum contribution limits. Your balances will be higher if the contribution limits are raised or if you are able to contribute over a longer period.
According to 2014 paper written by Paul Fronstin of the Employee Benefit Research Institute (EBRI), “a person contributing for 40 years to an HSA could save up to $360,000 if the rate of return was 2.5 percent, $600,000 if the rate of return was 5 percent and nearly $1.1 million if the rate of return was 7.5 percent and if there were no withdrawals.”
Do these scenarios beat what you would make in interest from a bank? Ah, yea….
Maximizing Your Benefits
If you decide to supercharge your HSA and build up your tax-free reserves, what’s the best strategy to use it? Here’s the strategy I plan on following:
- Begin saving receipts from QME’s from the day you open the HSA. Over time, you will have a proverbial shoebox full of QME receipts that can be submitted for a distribution anytime you need the cash. Want to take a nice vacation? Buy that boat? If you have enough QME receipts, you can get the money from your HSA and it won’t increase your taxable income 1 cent. It’s 100% tax-free since it is paying you for back QMEs. Until then, it will continue to compound and grow.
- If the account builds to a significant amount, you can invest it into a vehicle that provides a consistent passive income stream (e.g. real estate). This passive income could provide tax-free cash flow to pay for QMEs without dipping into the principal.
- When combined with a Roth IRA/401K, you will have two accounts to pull out cash when you want – and both will be tax-free. Providing you with two forms of tax-free retirement “income”.
The rules for paying for QMEs are summarized below.
- You receive tax-free distributions from your HSA to reimburse spending on QME’s you incur at the time of service or any time after the QME is made.
- QME’s are those incurred by you, your spouse and any dependents you claim on your tax return.
- Reimbursements for QMEs do not need to be taken in the same year as the QME occurred. QME reimbursements can occur at any point in the future as long as the specific QME being reimbursed was not included on a previous year’s Schedule A.
- If you take distributions for something other than QME’s, the amount you withdraw will be subject to income tax and may be subject to an additional 20% penalty.
- There is no penalty on distributions made after the date you are disabled or reach age 65.
- Distributions for QMEs can be taken for up to one year after the death of the account holder.
Upon your death, the entire HSA will be assigned to your spouse. When you and your spouse both pass, the funds become part of your estate. See future articles covering estate planning to learn how to pass this onto your heirs without incurring probate taxes.
How Do I Get Started & Set Up a Self-Directed HSA?
Once you enroll in an HDHP, the process to open up a Self-Directed HSA is the same as a Self-Directed IRA.
We covered the process in our article “How to Quickly Setup Your Self-Directed 401(k) or IRA.” detail, a simple process to open your Self-Directed plan. Link with and discuss the affiliate here – or have a link to a content upgrade and refer to it in the “supercharged” section above.
Both of the Administrators highlighted in the article provide services for Self-Directed HSAAs. You can contact them directly and they will walk you through the simple process.
New Direction IRA has a custom application form specifically built for friends of IAN.
American IRA has special discounts for friends of IAN. Simply check the “Referred By” check box on the application and write “IAN” on the space provided.