Optimizing Use of HSAs (Health Savings Accounts)
By Alan Silverstein, Fort Collins, Colorado.
Email me at firstname.lastname@example.org.
Last update: March 3, 2016
Here are some thoughts about how to most effectively use an HSA (health
savings account), for someone like me on an HDHP (high deductible
healthcare plan). This might interest you if you are early-retired in
the USA, meaning no longer on an employer's active or retiree plan
(assuming not HDHP, although some employers do offer those), not on
Medicaid (income not below 100% to 138% of FPL = federal poverty line,
depending on location) and not yet on Medicare (age 65 or disabled).
I won't repeat all the important details of how HSAs work. You can find
the rules on the web. For example here's one nice, albeit commercial,
Open it ASAP:
You should open your HSA as soon as you're eligible, even if you don't
put any money in it for a while, to start the clock on eligible expenses
that you can refund later ("incurred after the account is established").
Maximal HSA value
(payback for your time and trouble) comes from using your HSA funds for
all eligible medical and dental costs. "The more you spend the more you
save." Depending on your tax bracket, you can think of your HSA as a
"25%-off coupon" for all eligible expenses.
Why 25%? That's for people in the 300%-400% of FPL range, where they're
likely in the 10% federal marginal bracket, lose 9.5% of their PTC for
each (non-deducted) dollar of taxable income (really ACA MAGI = modified
adjusted gross income), and have a 5% marginal state income tax rate
(such as Colorado = 4.63%). Your mileage (HSA tax savings) may vary.
Anyway once money's contributed and sitting inside an HSA, I see no
reason not to distribute it back to yourself just as fast as you can
legitimately do so for qualified expenses. All of the benefit accrues
when you make deductible contributions, then the money is somewhat
restricted unless you're willing to pay penalties. Why try to dole it
out slowly to preserve more in the HSA for later?
You should build up enough money in your HSA (through annually-capped
contributions, see other websites for details) to cover any eligible
expenses for the next year or two, or at least have some headroom (not
yet contributed to the max) to do so "later this tax year" if the need
Max'ing out your HSA contributions over many years is debatable.
Upon your death it becomes an ordinary account 100% taxable to your
beneficiary in a single year -- unless it goes to your spouse. And if
your health insurance plan has an OPM (out of pocket maximum), why
bother? Then again, you might have significant eligible expenses not
covered by insurance (for example see
this list.) And in later years you might have large, uncovered but
eligible expenses like (non-supplemental) Medicare premiums or a nursing
home, for which it might be worth building up a reserve.
I decided it's good to max out your HSA contributions, at least insofar
as they give you useful tax deductions (otherwise it's not worth the
trouble). For most people there's not a lot of time to build up a
painfully large balance (potentially causing a taxable income spike to
an heir) before starting Medicare (usually age 65) and losing
eligibility to contribute. Then the accrued balance can be applied to
Only if deductible:
There's no point in making HSA contributions beyond your ability to
reduce your income taxes for a given year through the related deduction,
should you happen to owe $0 federal and/or state income tax in one
year... Unless you are OK with contributing effectively post-tax
dollars (no tax benefit up front) just to let them grow tax-free for a
long time. In which case, presumably you wouldn't keep them in a simple
checking account, but in some kind of higher-return investment vehicle.
Annual withdrawals (distributions):
Many HSA trustees allow you to pay-as-you-go for eligible expenses using
checks or debit cards. This can also help meet the IRS audit trail
requirement. But if you log your medical and dental expenses anyway,
and you don't mind carrying those expenses up to a year out of pocket,
it's simplest to just take a refund (distribution) from your HSA once a
year. There's no deadline, other than your demise, and I think actally
your estate has one year more to tap it for your eligible pre-death
expenses. (Not sure how that interacts with the HSA becoming an
ordinary account taxable to a non-spouse heir upon your date of death.)
If you also make your HSA contributions just once a year, say late in
the tax year after estimating your income tax situation (or even
retroactively before filing the return the next spring), then the HSA
becomes little more than a "revolving door": Once a year, put
money in (up to the limit or whatever lower amounts works for you), take
the tax deduction, then withdraw (distribute) one amount for all
unrefunded eligible expenses to date.
This is a strange game, but that's how the rules are written, as best I
can decipher them. An HSA is not very instantly-gratifying. You
must take solace in the intellectual awareness that all this foofahrah
indirectly saves you, say, 25% of a lot of money.
One-time HSA funding from a traditional IRA:
If you're over age 59.5, or even getting close, I think (although it's
surprising) that you should never bother using your one-time traditional
IRA trustee-to-trustee transfer to fund your HSA. Instead just take a
penalty-free traditional IRA withdrawal/distribution (taxable via 1099-R
as usual), and deposit it in your HSA (equally tax-deductible via
5498-SA), with the same result.
I believe this one-time transfer is only valuable when you're younger
and facing a penalty for IRA withdrawals/distributions. Assuming you're
on an HDHP that is.
The method above produces no net tax, but does require some tax return
bookkeeping. But I learned that a one-time IRA transfer is even worse.
And even worse, while you can retroactively fund your HSA until the tax
filing deadline, just like your IRAs, you can't do it using the one-time
traditional IRA transfer. That method results in a 1099-R only for the
actual year when the transfer occurred.
So what's the point of doing a one-time traditional IRA transfer at all?
Well if you're young enough (< 59.5) to face IRA early withdrawal
penalties, it's a way of knocking down a large trad-IRA balance
(minimizing RMDs many years later at age 70.5+) without paying a
penalty, thus diverting some of your IRA money into paying eligible
medical/vision/dental bills tax-free. (But not insurance premiums other
than LTC, or if on COBRA or disabled, or non-Medicare supplemental at
age 65+; nor OTC drugs unless you get a prescription for them.)
Other stray thoughts:
At the time of this writing (2015), my wife and I were new to HSAs
thanks to entering ACA marketplace HDHP-land after early retirement.
Why bother with HSAs at all? Well let's say you're in a 10% marginal
federal tax bracket and 5% state (4.63% in Colorado). Then for every
$1000 you spend on eligible expenses, you can save $150 in taxes...
Perhaps not immediately if you already have post-tax resources
available, but over the long run as you refill your spending bucket from
taxable sources, including future taxable income or traditional IRA
withdrawals. This beats 1-5% cash returns on a credit card!
Yeah this is "just a second-order effect," but paying attention to these
kinds of effects can increase how spendy or generous you can be in your
How much should you keep in an HSA? (Revisiting a topic mentioned
earlier in this webpage.) Enough to cover 1-2 years of worst case
out-of-pocket costs? Which is your HDHP deductible plus any vision or
dental expenses. Which, at least for us, is well in excess of the 2014
annual spousal combined HSA contribution limit of $8550 = $6550 split
between family members + $1000 each into own HSA for both being ages
But you need not build up your HSA to that worst-case number. Just have
enough "headroom" left this year to pass enough additional dollars
through the account, if you must for unexpected eligible costs, since
you can retroactively reimburse yourself for any eligible expenses
incurred after the account was open. Plus you can use your HSA funds to
pay for other family member expenses too.
I think you don't want a ridiculous amount to build up in an HSA anyway
since investment returns aren't that great, say 1% now at First Tech
FCU. Possibly higher with other kinds of trustees or investments? Also
upon death your HSA becomes an ordinary account fully taxable to any
non-spouse heir, less valuable to them than a properly handled inherited