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An increasingly popular investment account offers a 'huge advantage,' expert says — here's how

Twenty/20

If you want to cut your taxes while socking away money to cover health-care expenses, there's an increasingly popular option that's worth considering: a health savings account, or HSA. 

An HSA is a savings vehicle that allows people enrolled in a high-deductible health plan to use pretax dollars to pay for medical care. It has a triple tax advantage: Not only are your contributions pretax, but the money grows tax-free and can be withdrawn tax-free for qualified medical expenses. 

As of mid-2019, roughly 26 million people in the U.S. had an HSA, a 12% increase from a year earlier, according to a report from Devenir Research.

Given that the average American spends about $5,000 a year on out-of-pocket health-care costs, according to the latest consumer spending data from the Bureau of Labor Statistics, HSAs can offer significant savings.

An HSA is "very similar to an IRA," says Roy Ramthun, the president and founder of HSA Consulting Services, who runs the website Ask Mr. HSA. "You put pretax money aside for health-care expenses instead of retirement — it's a huge advantage."

How HSAs work

HSAs are akin to tax-advantaged retirement accounts. Their primary feature is that they can save you money on health-related purchases that insurance won't cover.

These accounts "are very useful because you can use them for dental and vision procedures, and other things that aren't covered by health insurance," says Carolyn McClanahan, a physician-turned-financial advisor who serves as the director of financial planning for Life Planning Partners in Jacksonville, Florida.

VIDEO4:0304:03
What is a health savings account (HSA)?

Video by David Fang

You can contribute up to $3,550 to an HSA in 2020 for individual coverage and up to $7,100 for family coverage. Other people can contribute to your account, too. For example, your employer may provide a match, similar to a 401(k). Family members, like your parents, can also make contributions on your behalf.

The tax-advantages make HSAs a particularly attractive tool. There are three main tax benefits:

  1. Your HSA contributions are either pretax or tax-deductible. Your HSA contributions will reduce your taxable income for the year. They also avoid Social Security and Medicare taxes, helping you keep even more of your paycheck. 
  2. Your earnings typically grow tax-free. You can keep the money in a saving account component that earns interest, or invest your HSA contributions. There's no need to use the money in the same year you contribute. It can roll over from year to year.
  3. You can withdraw money tax-free if it's used for qualified medical expenses, which are listed on the IRS website. Otherwise, you'll incur a 20% penalty, and pay taxes on those withdrawals. Once you reach age 65, you can also withdraw funds without penalty to cover nonmedical expenses in retirement — although you will pay taxes on that money. 

In order to open or fund an HSA, you must be enrolled in a qualifying high-deductible health plan. Currently, the government defines that as plans that have a deductible of more than $1,400 for an individual and at least $2,800 for a family. Take a look at your insurance costs and coverage before you sign up to make sure this kind of account makes sense for you. 

3 smart ways to use your HSA

In response to the coronavirus pandemic, lawmakers made some changes as to how people can use their HSA funds as a part of the more than $2 trillion stimulus package. Here are a few smart ways to use HSA money to offset bills.

1. Cover insurance premiums. Typically, you can't use your HSA money to pay for your insurance premiums. But there are now some exceptions. Specifically, you can use HSA funds to pay health insurance premiums if you are currently receiving unemployment benefits, or if you're on a COBRA plan. 

2. Offset drugstore purchases. Before the crisis, over-the-counter medicines, such as pain relievers like Advil or Tylenol, were not eligible HSA expenses. Neither were personal hygiene products like tampons and sanitary pads. Now they are, along with a host of other products like thermometers, batteries for medical devices, prescription glasses, cold and allergy medicine, and first aid items.

3. Create an alternative emergency fund. If you can afford to pay out of pocket for medical expenses and avoid tapping your HSA, that can be a smart move, McClanahan says. That lets your balance continue to grow. But hang onto your receipts for qualifying medical expenses. You can redeem those at some point in the future when you need cash for an emergency.

"Think of your HSA as a part of your emergency fund," she says.

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