Optimizing Use of HSAs (Health Savings Accounts)

By Alan Silverstein, Fort Collins, Colorado. Email me at ajs@frii.com.
Last update: August 5, 2020

Contents:

• My Suggestions
• One-Time HSA Funding
• HSAs Are Stupid and Unnecessary
• Other Stray Thoughts

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, website.

My Suggestions

• 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. (See also this external website: Complete List of Eligible HSA Expenses.) "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?

• Adequate balance: 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 arises.

• 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.

  Later: 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 Medicare premiums.

• 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 actually 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

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.

Details:

• 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+, or later, age 72.0+) 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.)

HSAs Are Stupid and Unnecessary

I know a lot more than most people about HSAs. I have some years of experience operating them (including one major mistake), plus I received training on how to tax-report them while a volunteer preparer. So forgive me a moment while I spout off about how utterly dumb they are -- but unfortunately still too valuable to ignore.

You'll read opinions from financial experts saying how HSAs are triply joyous because they feature:

• tax-deductible contributions (up to a limit, if you qualify and don't screw up, and if the deductions do you any good), and
• tax-free growth (OK sure), and
• tax-free distributions (for qualified medical expenses, if you follow all the rules).

This is all true, but come on... If the federal government wants people to pay for qualified medical expenses tax-free, why don't they just allow individuals to take above-the-line adjustments (deductions) for them, and be done with it? Get rid of all the hidden complexity behind HSAs, FSAs, and all of their evil brethren, and remove medical deductions (subject to a hurdle) from Schedule A too.

"But health savings accounts encourage saving money ahead of needing to spend it!" Yeah, right. Some people are willing and able to actually do this, but behavioral economics explains why most people don't, unless you make it a default behavior.

The devil is in the details, and HSAs have a lot of ugly details when you examine them closely.

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 later years.

• 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 55+.

• 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 IRA.