The Best Ways to Use a Health Savings Account

I recently ran the numbers and it seems to me it would be better to use my Health Savings Account (HSA) dollars for healthcare expenses now, rather than using them as a “Stealth IRA” after age 65. What is the best way to use my HSA?

A.

It is quite possible that it is smarter to use your HSA dollars for health expenses this year rather than letting them compound for decades and then using them to buy a boat, but there are 7 guiding principles that should be applied when deciding how to use your HSA.

Principle #1: An HSA is your only triple-tax-free account

When you contribute to an HSA, you get a current year tax deduction. Your money also grows in a tax-protected manner over the years. Finally, when you pull the money out, as long as you spend it on healthcare, it comes out of the account tax-free. This is better than “double tax-free” 401(k)s and Roth IRAs, so the HSA should be the first investing account you fund each year, after ensuring you receive any available employer match.

Principle #2: An HSA should be allowed to compound for as long as possible

Since the HSA is completely tax-free, it should grow faster than any other account. Thus, it is best to keep the money in that account for as long as possible to allow maximal compounding of your investments.

Principle #3: HSA dollars are best spent on healthcare

HSA dollars can be spent on anything, but if you spend them on non-healthcare expenses prior to age 65, you will not only pay taxes at your marginal tax rate on the entire withdrawal, but you will also pay a 10% penalty. After age 65, that penalty goes away, but you will still have to pay taxes on the withdrawal. Because of these taxes and penalties, it is best to spend HSA dollars on healthcare, but if you must spend it on something else, do so after age 65.

Principle #4: Spend your HSA prior to death

When you and your spouse die, your HSA money becomes fully taxable income to either your estate or, if you have named a beneficiary, to the beneficiary. There is no such thing as a “stretch” HSA. Thus, it is one of the worst types of accounts to inherit. It is far better to inherit a Roth IRA, life insurance, or even a traditional IRA. So try to spend your entire HSA prior to dying and leave something else to your heirs.

Principle #5: HSA dollars do not have to be withdrawn in the same year as the healthcare expense

Although this rule may change at the whims of Congress, as the law currently stands you do not have to withdraw money from your HSA in the same year you purchase healthcare. Thus if you have a baby at age 35, if you keep your receipts, you can take that HSA money out at 55 and use it to buy a boat, tax and penalty-free.

Principle #6: The higher your tax rate, the more beneficial it is to use the HSA instead of non-qualified (taxable) dollars

If you have a 50% marginal tax rate in your peak earnings years, but only a 30% marginal tax rate in retirement, there is an advantage to using HSA dollars earlier in life. However, this advantage is frequently outweighed by the long-term, tax-free compounding and the ability to invest more aggressively in the HSA due to the longer time horizon.

Principle #7: HSA dollars are not protected from creditors

Although there are a few states which exempt HSA dollars in bankruptcy, (FL, MS, OR, TN, TX, and VA) most states do not. Thus, in the event you are the very rare target of a successful lawsuit with an award beyond your insurance policy limits, it is generally better to have money in a 401(k) or Roth IRA than an HSA.

So how can we apply all of these principles to determine the best way to use an HSA? The very best way is to use an HSA to pay for all of your healthcare benefits throughout your life. This allows you to purchase all of your healthcare with pre-tax dollars. However, your future healthcare expenses are completely unknown. Your HSA may either be much larger than your healthcare expenses, or it may be much smaller than your healthcare expenses. So you have to make an educated guess, and then adjust as you go along in order to arrive at the optimal strategy. If you think your HSA is larger than future healthcare expenses, be sure to spend it on any available healthcare expense you may have throughout your life. If you reach age 65 and still have a huge HSA, then treat it like a regular old IRA, spending it on any expense with the aim of having the account keel over at the same time or just before you do. If you think your HSA is smaller than future healthcare expenses, then pay for your current healthcare needs with non-qualified (taxable) dollars, and save that HSA for retirement healthcare expenses. If you are not sure, then spend using taxable dollars now, but keep your receipts.

A Health Savings Account is a great way to reduce your taxes and decrease the after-tax cost of your healthcare. Using it optimally will allow you to maximize your spending, giving, and financial security throughout your life.

Dr. Dahle is not an accountant, attorney, insurance agent, or financial advisor. He blogs as The White Coat Investor and is the author of the best-selling “The White Coat Investor: A Doctor’s Guide to Personal Finance and Investing.”