Should You Max Out Your HSA Contributions?

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Some powerful tax advantages are available when you max out your health savings account (HSA). Your HSA can turn out to be a significant component of your retirement nest egg.

Key Takeaways

  • A health savings account (HSA) is an account specifically designed for paying health care costs.
  • The tax benefits are so good that some financial planners advise maxing out your HSA before you contribute to an IRA.
  • You’re eligible for an HSA if you’re self-employed, but most people get their accounts through their employers.
  • Having money set aside for health care expenses—which could also include long-term care later in life—frees up your other retirement savings.

What Is an HSA?

A health savings account is a tax-advantaged savings account specifically intended for paying health care costs. Contributing to and using the account to pay for qualified medical expenses gives you a significant discount on your health care costs, and it's a powerful tool for retirement saving.

There are penalties for using your HSA funds outside of their intended purpose of paying for medical expenses.

But the penalty for using the money for other than medical purposes is steep: You'll pay income tax on the funds withdrawn, plus a 20% penalty. This changes when you reach age 65, however. You'll still enjoy tax-free use of your HSA funds for qualified medical expenses, but you won't pay the 20% penalty if you decide to access your money for non-medical uses. You must still pay income tax, however.

Do You Qualify for an HSA?

Not everybody qualifies for an HSA.

The main rule is that you must be covered by a high deductible health plan (HDHP). These plans require that you pay a significant portion of your health care costs upfront before your insurance kicks in. The plan must require that you pay at least the first $1,400 ($2,800 for family plans) and a maximum of $7,050 ($14,100 for families) as of 2022 to qualify for an HSA.

The IRS indexes most of these thresholds to keep pace with inflation, but the $1,400/$2,800 rule for deductibles remained unchanged for calendar years 2020 through 2022.

You must pay these amounts before insurance pays anything in order to qualify for an HSA. That means you’re responsible for the insurance-adjusted costs of doctor visits. You'd have to pay $150 if the doctor charges the insurance company $150 for a visit each time until you reach the amount of your deductible. But you can use your HSA balance to pay these costs.

HDHPs often cost less than other health insurance plans, and they probably qualify for an HSA if you can afford to shoulder those portions of your medical care upfront.

You can’t take advantage of the benefits that come from holding a balance long-term if you use your entire balance each year. It's best not to think of your HSA as an investment vehicle if you know you'll deplete the balance each year.

Why Max Out Your HSA?

Some financial planners advise maxing out your HSA before contributing to an IRA because the tax benefits are so good. You get a tax deduction when you contribute funds, and you can roll over your funds from one year to the next. You don’t pay any taxes on the money upon withdrawal as long as you use the money to pay qualified medical expenses or, if you're 65 or older, qualified health insurance premiums.

You get just one or the other with an IRA. You get tax advantages when you contribute or when you withdraw, but not both. You get the tax benefits on both sides with an HSA.

There Are Contribution Limits

You can contribute a maximum of $3,650 or $7,300 for a family (the same limits that qualify for a tax deduction) as of 2022. Like other retirement accounts, these limits can adjust from year to year based on inflation rates. You can redirect contributions to an IRA, a 401(k), or another retirement account when you reach the maximum. Just like other retirement accounts, you’re allowed another $1,000 in catch-up contributions once you reach age 55.

Penalties for Unqualified Withdrawals

Your HSA funds must be used for qualified medical expenses. You'll pay ordinary income taxes on the withdrawal plus that 20% penalty if you use the money for anything else and you're under age 65. You could pay nearly 50% or more in taxes and penalties if you don’t use the money for its intended purpose. But you can use your HSA funds for things other than medical expenses after you reach age 65. You'll pay only ordinary income tax on those withdrawals.

Think of it as adding an extra $3,650 or $7,300 to your Roth IRA's annual maximum contribution if you’re in good health or can pay those medical costs out of pocket until you reach your deductible.

Understand How Your HSA Funds Are Invested

Do some investigating before using your HSA as an investment vehicle. First ask about the company that will hold the HSA funds for you if your employer offers you the HDHP with a health savings account. You won’t get much benefit from maxing it out if it’s nothing more than a basic savings account because the money isn’t being invested and earning better returns.

Many companies will allow you to invest the funds into something more aggressive than a traditional savings account. The HSA becomes a vehicle for wealth building if your account comes with investment options.

Don’t Forget About It

Your HSA is your account to take with you if you leave your current employer, just like a 401(k). You can contribute to your HSA as long as you remain enrolled in an HDHP. Don’t forget about your account. Collect all the information about it from your human resources department.

Some Simple Math Shows the HSA's Power

Let’s say that the maximum contribution never went up, and you contributed the maximum for an individual each year ($3,650) for 20 years and you earned a 4% rate of return.

We’ll use a very conservative return rate because you'll have some years where you'll have to withdraw funds for medical expenses. Using these numbers, you would have a balance of over $111,000 that is completely tax-free if it's used on qualified medical expenses.

Your medical expenses will become a larger part of your monthly budget as you age. Having this much money set aside for expenses that could also include long-term care later in life frees up your other retirement funds for more discretionary spending.

Don’t view your health savings account as something to zero out before the end of each year. This is a valuable tool in your retirement savings arsenal.

Frequently Asked Questions (FAQs)

Do HSA funds expire?

HSA funds don't expire. The funds can be used at any time, as long as they're used for a qualified medical expense.

How do you open a health savings account?

The process of opening an HSA is similar to opening a retirement account. Your employer may help you open an account, your current bank may offer HSA accounts, or you can search for financial institutions that will provide an HSA account.

What can I spend the money in my health savings account on?

The rules for what you can spend HSA funds on are generally the same as determining what qualifies for claiming medical expense deductions. These expenses include medical services from physicians and surgeons, transportation to medical appointments, and the costs of medicine and medical equipment.

Article Sources

  1. Internal Revenue Service. "Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans."

  2. Internal Revenue Service. "Rev. Proc. 2021-25," Pages 1-2.

  3. Internal Revenue Service. "Internal Revenue Bulletin: 2019-22."

  4. Internal Revenue Service. "Internal Revenue Bulletin: 2020-24."

  5. Centers for Medicare & Medicaid Services. "What’s a Health Savings Account?" Page 2.