All About Health Savings Accounts (HSAs)

Today's topic on Finance 101 is about HSAs Health Savings Accounts. HSAs are a beloved account by personal finance enthusiasts because of their incredible tax efficiency and tremendous flexibility. Before we get into those details, let's zoom out and talk about the two major categories of health insurance plans offered by most employers and available in the marketplace. There are more than two types of health insurance plans. There are PPOs, HMOs, EPOs, point of service plans, high deductible health plans, and more. For purposes of this conversation, we're going to talk about high deductible health plans and then non high deductible health plans. For simplicity, I will refer to the basket of non high deductible health plans as PPO plans. Most of us are very familiar with how the PPO plans work. Your kid gets strep throat, you go to the pediatrician, you pay the $30 copay. The insurance pays the rest. This is the cadence most Americans are accustomed to. It is easy to understand. It is easy to plan for. A high deductible health plan works differently. These plans offer lower premiums in exchange for higher out of pocket costs. The insurance doesn't pay for anything until you have reached the high deductible, which is often around two or three thousand dollars. So now when our kid gets strep throat, we do not pay a $30 copay at the pediatrician's office. We pay the entire $300 office visit. This is not the cadence most Americans are familiar with. It can feel confusing and it can be difficult to plan for. For this reason, high deductible health plans or HDHPs for short, are unfortunately underutilized in our country. I say unfortunately because HDHPs represent an opportunity for many of us to save on overall healthcare costs and to build significant wealth over time. A primary way they help save on overall costs is because the monthly premiums are typically meaningfully lower than the premiums on the PPO plans. And they should be. If you're paying $300 for strep throat visit instead of 30, you are saving the insurance company money, and thus it makes sense for the insurance company to charge you less for this type of coverage. For an average family of four, I usually see that an annual high deductible health care Premium might be $1,000 to $3,000 less than the PPO premiums. That's not always the case. You need to check your own, but that's often what I see. The annual savings on premiums is critical to keep in mind when you are paying the $300 pediatrician bill instead of the 30. It can feel shocking at first to pay the full cost of the visit, but you have to remember that you are already several thousand dollars ahead each year just by virtue of saving on your premiums. Now having those lower premiums is nice, but the real magic with a high deductible health plan happens because an HDHP is the key that unlocks the glorious door of the Health Savings account. You must be enrolled in a high deductible health plan to save into an hsa. Congress has set up a system that allows us to use pre tax money to pay for our healthcare cost under both the PPO and HDHP plans. For the PPO plans we can use a flexible spending account or fsa. With an fsa, your employer sets the money aside from each paycheck into this flexible spending account that you can use to Pay for your $30 co pays prescriptions or any additional medical, dental or vision costs during the year. Often you get a special FSA debit card that you can use directly to pay for these expenses. This is great because anytime you can pay for things with pre tax money, you are getting a discount equal to your marginal tax rate, which can be 40 to 50% for many high earners. The downside of an FSA is that it is use it or lose it money. If you set aside $2,500 for the year and you only spend $1,500, you lose that thousand bucks you didn't use. This is why you see people at Costco in December with carts full of Contact Solution and Metamucil. They're trying to use their FSA money on qualified medical supplies before the money evaporates at the end of the year. With a high deductible health plan, the way that we use pre tax money to cover qualified health care expenses is with an hsa. It's similar to the FSA that we just talked about, but with some incredibly meaningful differences. The similarities are that this is also typically funded by payroll withholdings in a separate account. A debit card is also often provided so you can pay for the $300 pediatrician visit with pre tax money. That's where the similarities end. Now let's talk about the differences. A health savings account is a triple tax protected account. What do I mean by triple tax protected? The first layer of tax protection is that the amount you contribute to the HSA lowers your taxable income each year and thus lowers your tax bill accordingly. In 2024. The maximum you can contribute if more than one family member is covered by the HDHP is $8,300. The limit for if only one person is covered is half of that 4,150. For someone who is in the 32% federal tax bracket and 8% state tax bracket, their marginal tax rate is 40%. So if they contribute 8,300 to their HSA, they save $3,320 on taxes every year. This is also critical to remember when you are paying the $300 strep throat bill. Not only did you save a couple thousand dollars on your premiums, now you've saved another couple thousand dollars on taxes. For most high earning families, using an HSA saves them between $2,000 and $5,000 between lower premiums and tax savings every single year. That is a pretty big head start each year when it comes to reducing your overall healthcare costs further because the premiums are cheaper for your employer as well. In hopes of enticing you to use the hsa, many employers will make a contribution to your HSA on your behalf. It's not uncommon for employers to chip in 500, $1,000 or $2,000 to your HSA. That is free money. Just like your 401 match is free money. Your HSA match is money you are leaving on the table if you don't opt into it. Keep in mind that the annual contribution limit to the HSA is the combination of both of your and your employer's contributions. So if your employer puts in $1,000 in 2024, you can put in the other $7,300 to hit the overall $8,300 limit. The second layer of tax protection is that this is not use it or lose it money. This money is yours forever even if you don't spend it all during the year. Even if you leave your employer, even if you opt out of a high deductible health plan in the future. No December Costco shopping sprees needed. This money is yours and you can invest it within the HSA and stock and bond index funds just like any other investment account. The growth on those investments each year is tax free. You don't owe any tax as the investment grows or kicks off dividends each year. Tax protection number three is that when the money is withdrawn for qualified medical expenses, there's no tax due on it then either. This is the only money in America that routinely passes from ordinary income all the way around to expenses with no tax due. Now the way this money is meant to be used is you go to the pediatrician, it's 300 bucks and you're meant to whip out your HSA debit card to pay the bill. There's nothing inherently wrong with this idea, but I don't want you to do that. I want you to cut up the debit card. That's because the tax free nature of this account is so mathematically profound that we don't want you pulling money out of the account. We want this HSA to benefit from as much compounding growth as possible for as long as possible. If you can start maxing out an HSA every year in your 20s, invest the money wisely. Do not withdraw money from the account during your career. Then you can have well over a million dollars in your HSA by the time you are 65. Now you have a completely tax free way to pay for what is often the highest expense for retirees, which is health care, including Medicare premiums. This can meaningfully change the time when you reach financial independence. So if this isn't sounding awesome enough already. Wait, there's more I mentioned these accounts are the darling of personal finance enthusiasts, both because of their tax efficiency, but also because of their versatility and flexibility. To understand what I mean by that, we must first outline a few rules about HSAs. Most importantly, if you take money out of an HSA prior to age 65 for non qualified expenses, you must pay ordinary income taxes on the withdrawal and there is a 20% penalty. The IRS wants to discourage you from buying a boat at age 55 with your HSA money. But one of the really cool things about an HSA is that after age 65 that 20% penalty goes away. If you are healthier than expected in retirement and don't need all of that money for health care, you can take the money out and buy that boat if you want to. The withdrawal is still subject to taxation just like a pre tax 401 would be, but the 20% penalty is gone. This is an incredible benefit and why Jim has been known to call the HSA a stealth Iraq. It's really just another retirement account with better tax treatment when used for health care. Now if you really want to optimize, you can make sure future withdrawals are tax free and penalty free at any age. We call this the save the receipts strategy. The way this works is that you pay out of pocket for your health care costs over the years, not using your HSA money and you are saving the receipts as you go. Personally, I take a photo with my phone or a screenshot on the computer and save them digitally as physical paper receipts can degrade over time. Now let's say that over 10 or 20 years you have $30,000 in medical and dental expenses. I'm going to get half of that just putting my three kids in braces over the next few years. The reason to do this is that any time in the future you can reimburse yourself for past medical expenses using your hsa. That reimbursement is tax free and penalty free at any age. So if you retire early and you're 55, you can buy a $30,000 boat using your HSA dollars. Because you are simply reimbursing yourself for $30,000 of past medical expenses as documented in the receipts you have saved prior to age 65. This saves you both the tax and the penalty. After age 65, it's saving you the tax that would have been owed on the non qualified withdrawal. Okay, that's the story with HSAs. They're pretty cool. Give strong consideration to one if you have access to one. High deductible health plans are not scary. They are still real health insurance that you have out of pocket maximums similar to PPO plans. So it's not like you're going to have to pay $100,000 if you're in a car accident or you get cancer. They all have the same protections as all other plans under the Affordable Care Act. You pay a little more upfront at the doctor's office in exchange for lower premiums, lower taxes and tax free withdrawals that can be used for anything. If you combine all the techniques we just discussed, it's a really good deal and a near no brainer for most high earners. This podcast is for your entertainment and information only. It should not be considered professional or personalized financial advice. You should consult the appropriate professional for specific advice relating to your situation.