Health Savings Account (HSA) does not sound like a retirement account. I know, it’s confusing. In a way, it was probably not designed to be a retirement account, but it ended up being the queen of them all.
Each chess piece has its advantages and limitations: a pawn can only move one space at a time, bishops can only move diagonally, rooks only horizontally or vertically etc. Queens can move in any direction, as many spaces as desired, making them the most valuable piece of the game.
In the game of retirement, the HSA is the queen. To understand why we will compare retirements accounts with regards to taxes and income limitations.
Unlike traditional or Roth IRA, there is no income limitation for an HSA plan. (There is no way around the income limitations of a traditional IRA but there is a way around the income limitations of a Roth IRA called the Backdoor IRA).
Taxes on the way in
Money going into your HSA can be deducted from your taxes. This results in significant savings now. To know how much money you will save, calculate your marginal tax rate. In Nebraska, the highest tax rate is 6.84% and the highest federal tax rate is 37%. For a high-income earner, the marginal tax rate would then be 37% + 6.84%=43.84% which we will round to 44%. So for every $1000 you put into your HSA, a high-income earner can save up to $440! Savings will be less for people in lower tax brackets. For the median American household income of $56,000, the marginal tax rate would be 17% (5% Nebraska, 12% federal). That would translate to $170 saved per $1000 contributed to the HSA.
Traditional IRA’s also offer savings on taxes now but not everyone can contribute to them due to income limitations. On the other hand, Roth IRA’s are taxed on the way in and thus offer no savings now.
The HSA, as well as all retirement accounts, offer tax-free growth. This means that capital gains and dividend payments are not taxed if the money stays in the account. Contrast this to a brokerage investment account where every year you have to pay taxes on dividends earned as well as on any shares sold where you made any capital gains. These taxes constitute a huge drag for these accounts.
Taxes on the way out
Money from your HSA is not taxed on the way out as long as the money is used to pay for qualified medical expenses. If you are 65 or older, money from your HSA can be used for anything but it will be taxed at your current tax rates (just like a traditional IRA).
After age 59 1/2, money can be withdrawn from traditional and Roth IRA’s penalty-free. A traditional IRA is taxed on the way out at your current rate but money from a Roth can be withdrawn tax-free.
How to best use an HSA
Since HSA is queen, you will want to give it preference over rooks (traditional IRA) or bishops (Roth IRA). That means if money is limited and you have to choose between accounts, you should choose the HSA.
The best use of an HSA is not to use it as a savings account to pay your current medical expenses but to use it as an investment account to fund medical expenses after age 65.
HSA step by step:
- Open an HSA account (Lively and Fidelity offers the lowest fees and has great investment options.)
- As soon as possible start contributing to your HSA account. Maximize your HSA (limits for 2019 are $3,500 for individuals and $7000 for families).
- As soon as the money is on Lively HSA, invest it on TD Ameritrade commission-free ETF’s as follows:
- The simplest portfolio is to invest all the money on SPTM (SPDR® Portfolio Total Stock Market ETF, Expense Ratio of 0.03%). If you leave the money untouched for 20 years you will likely come far ahead compared to the portfolios below.
- If you want to add bonds to minimize the volatility use SPAB (SPDR® Portfolio Aggregate Bond ETF, Expense Ratio of 0.04%).
- If you want to diversify the portfolio you could add international stocks with SPDW (SPDR® Portfolio Developed World ex-US ETF, Expense Ratio of 0.04%), and real state with USRT (iShares Core U.S. REIT ETF, Expense Ratio of 0.08%).
- Open a Dropbox, Google Documents or OneDrive account and start scanning all your medical receipts into a folder in your account. Receipts can be submitted at any time to withdraw money from your HSA penalty and tax-free when you need it.
- Repeat every January 1st starting on step 2 and increase it if the limits have changed.