James Canole (0:00)

I believe health savings accounts are one of the most effective places you can invest your money, but only if you know the rules around how to properly use them. So in today's episode, we're going to talk about health savings accounts, how they work and some strategies, some little known strategies that you can use to maximize the tax impact of everything you contribute to your HSA plan. This is another episode of Ready for Retirement. I'm your host, James Canole and I'm here to teach you how to get the most out of life with your money. And now onto the episode. Let's start by getting a quick rundown of how health Savings Accounts, or HSAs, work. With an HSA, any contributions you make are tax free at the federal level and they are tax free at the state level at all but two states. So California and New Jersey do not recognize HSA contributions, But the other 40 out of 50 states do, and those contributions are tax free. Now, these contributions also continue to grow tax free. So with an hsa, and we'll get to this in a little bit, you have to keep some of your money in cash, but you can invest the difference, you can invest the remainder and that money grows tax free. And then if you are pulling that money out for qualified medical expenses, we'll also get to that a bit later, that money comes out tax free. So what you essentially have is you have a triple tax benefit here of tax free contributions, tax free growth and tax free withdrawals. And what I'm going to show you is how do you take most advantage of this in some little known ways to maximize the effectiveness of what this account can do for you? The first detail to know with this is are you even eligible for an hsa? To be HSA eligible, you have to be enrolled in a high deductible health plan. Now, just because you believe that your health care plan has a high deductible does not necessarily mean that it is a high deductible plan. These plans will have minimums for the actual deductible involved with it and they'll have maximums for out of pocket costs. And the plan itself will say whether or not it is high deductible and whether it is HSA eligible. But that's the first thing. If you don't have a high deductible health plan, you cannot use an HSA or you cannot contribute new dollars to an hsa. An HSA doesn't mean that it's HMO or ppo. You can have an HSA with both. The main thing that you need to look at here is is this a high deductible health care plan and is it HSA eligible? The second detail that you need to be aware of is the contribution limits. And pay careful attention to this because this is slightly different than how something like a 401k works. If you have an HSA for an individual only, the most that you can put into that plan for a year is $4,300. If it's a family plan, the most that you can put in is $8,550. But here's what's different about how these contributions work when compared to something like a 401k. When you have a 401k and we talk about contribution limits, that is the amount that you personally can put in to your 401k. Any employer contributions don't count against that limit that you have for yourself with HSAs, however, this is a total contribution limit. So if you're single and you have an HSA for yourself only, and let's say that your employer puts in $500 to your HSA, that $500 counts towards the $4,300 limit, which means that you can only put in $3,800. So keep that in mind. These contribution limits are the combined amount that you and your employer puts in. Another thing that's slightly different than what you might be used to with 401ks is with 401s, as soon as you are 50 or older, you get to make a catch up contribution. The same concept applies with HSAs, but the catch up contribution is an extra thousand dollars and it's from 55 and older, not 50 and older like 401ks are. So once you're 55 or start making these catch up contributions to your HSA to get even more money into the plan, the next thing to note with HSAs is there's a lot of confusion. Now sometimes people will ask, isn't an HSA one of those use it or lose it accounts? And the answer is no. The use it or lose it account that people are typically referring to is an fsa, a flexible spending account. That is an account that you contribute to it and you need to use those dollars by the end of the year, otherwise those dollars go away with a health savings account. And keep this in mind because this is going to tie into the strategies we talk about here. In one second, with an hsa, any contributions that you make, those carry forward with you, you begin growing this account balance that you do not lose. If you don't use those contributions by the end of the year. Just a few more details, a few more things that we want to lay the groundwork on before we start to talk about the strategy around HSAs. But one other important thing to note is unlike IRAS or Roth IRAS, there's not an income limit. Does not matter how much you earn, you can make HSA contributions at any income level provided you are enrolled in a high deductible health plan. So let's now get into some of the strategy here, some of the things that you can do with your HSA to significantly leverage the tax impact that you have here and possibly make this one of the core assets that you have to prepare for your retirement. Now, before we do, real quick, make sure that you subscribe to the show. If you're listening on YouTube, subscribe at least on Apple podcasts, on Spotify. Wherever you are, make sure that you subscribe so you don't miss future episodes. So what can you now do with these HSAs? One really important thing to note here that very few people actually understand is you do not have to use your HSA funds in the same year that you incur a qualified medical expense. So as I mentioned at the beginning, contributions to the HSA are tax free, growth is tax free with the exception of New Jersey and California, and withdrawals are tax free, assuming you're using those withdrawals or you're using that money that you pull out for qualified medical expenses. The beautiful thing is you don't have to align the year in which the qualified medical expense is incurred and the year in which you pull funds out of your HSA. So, for example, let's assume that I personally put $5,000 into my family's HSA this year. And let's also assume that this year I incur a medical expense that cost me $3,000. What I could choose to do is I could choose to pull $3,000 from my HSA to pay for that medical expense, or I could simply use my cash. I could use money from my bank account to pay for that $3,000 medical expense and leave the full $5,000 in the HSA. Here's what that does. Now my HSA can continue growing and let's assume that five years from now, 10 years from now, I need some extra cash. And I'm trying to figure out where should I pull this from? Well, in that year, even if it's five or ten or however many years from today, I can still pull that $3,000 out because I incurred an expense. And that $3,000 that I pull out still counts as a qualified medical expense. Even if 2025 is the year that I incur the actual medical expense, I can pull the funds out in 2030, 2035, 2040. It doesn't have to correspond to the that I maintained or incurred the expense. Now, pro tip. This is why it's very important to keep track of your medical expenses. If you're incurring medical expenses and you have a health savings account, but you're using cash flow to pay for those expenses, meaning you're using other assets outside of your hsa, keep track of that. Because here's where the beauty comes into play. Let's assume that every year for the next 10 years, I incur $3,000 in medical expenses. And let's also assume that every year for the next 10 years, I'm contributing $5,000 to my family's HSA account. So that's 10 years of contributions. That's $5,000 per year. So $50,000 of contributions. But let's assume that that money's grown because I've invested it and it's now worth $75,000. That's $75,000. And of that $75,000, I essentially have $30,000. 10 years of $3,000 per year of expenses. I have $30,000 that I can pull out tax free at any time. It doesn't have to be at that point for an actual medical expense. If I want to take my family on a really nice trip, I have $30,000 of tax refunds there. If I run into hard times and I need to pull money from somewhere, I have $30,000 of tax free funds there. So this is one of the beautiful things about health savings accounts, is you can use it to start building this beautiful portfolio knowing that part of that portfolio can always be tapped into completely tax free in the event that you need it. Even if you don't have a medical expense in that year, assuming you have incurred medical expenses up until that time. Now, I mentioned this briefly earlier, but one point that I want to hit home on again is with an HSA account, usually you're going to be required to keep some minimum amount in cash in that account. So if I'm funding my account with $5,000 per year, my HSA provider, of which there was many of them, they might require me to keep $1,000 simply in cash. All new contributions will go to cash, but they will give me the option of investing anything above $1,000. So the first thousand I put in that SSA in cash, the next thousand, the next 2,000, the next 10,000, 20,000, etc. I can start investing that money and I can start growing that money. And keep in mind that is tax free, all that growth is tax free. And then if I pull it out for qualified medical expense, also tax free. So let's now look at a bit more in depth of a case study here to really illustrate some of the tax savings power that these accounts have. Let's look at John. John is 40 years old and he's going to work until the age of 60. Every year John puts in $5,000 to his health savings account, which means John gets a $5,000 tax deduction for doing so. Now, of course, we have to assume that John's married in this case because his limit would be $4,300 if he was single. So we're just making some assumptions here using some round numbers. $5,000 the next 20 years. So if John happened to have $5,000 every single year in medical expenses, what he's done is every year he has been able to write off that $5,000. Why has he done this? Well, the $5,000 contribution to his HSA, that was a tax deduction. So write off is the wrong way of saying it. It is a deduction against his income. And then he uses that tax free money to pay for his medical expenses. So over 20 years, John has effectively deducted $100,000 of medical expenses that would have been taxable to him had he not put money into his HSA. So that's a great starting point. $100,000 saved over 20 years. That's significant. That's what most people are doing with their hsa. Now let's take a look at another strategy John could have employed to really leverage the tax benefits. So that first option is great, lots of money saved, but can he do even better? Well, let's assume that John has the exact same scenario, $5,000 of contributions from age 40 to age 60 and he incurs $5,000 of medical bills. This could be him, his family, anything. So $5,000 medical expenses in this scenario. Let's assume that now John pays for those $5,000 of medical expenses out of his cash flow. He's building up his hsa. So every year that's growing while he is paying for cash for his medical expenses as he goes. If those $5,000 of contributions he is making to his HSA, if he is investing that, and let's assume that he grows at 8% per year. Just use a simple number here, not a guarantee, just for illustrative purposes only. $5,000 growing at 8%, doing that for 20 years, John would have just under $290,000 in his HSA account at the end of this 20 year time period. So now what can John do? Well, at age 60, John has caught $290,000 in this account. Of that account, $100,000 can be taken tax free at any time. That $100,000 is because John's been saving his receipts as he's incurred these qualified medical expenses. That's $100,000 of tax free money, very much like a Roth IRA at this point that John has available to him. In addition to that, the remaining $190,000 that can still be taken tax free for new qualified medical expenses. So what counts as a qualified medical expense? Well, obviously things like going to the doctor, things like paying for that expense. But what about COBRA premiums, certain long term care insurance premiums, Medicare premiums, not Medigap, but Medicare premiums, all these things, things that you will have in your retirement. How great would it be if you had a tax free way of paying for those things? That's exactly what could happen in this case for John is of his $290,000, which keep in mind, that can keep growing. It doesn't have to stop growing simply because he retired. He essentially has $190,000 to cover these things. Medicare premiums, COBRA premiums, maybe between age 60 to 65 or other insurance premiums, actual health care costs. He has a good chunk of money to do that. Not to mention he has $100,000 that he can do whatever he wants with. If he wants to draw that money at any time that money is tax free because as I mentioned before, he's already had the medical expenses that he could attach those to, even though he didn't pull the money out in the same exact year. So that's an incredible strategy that can yield lots of tax free income to you in your retirement. Now a couple more things here to wrap this up and make sure that you're truly using your HSA to its fullest extent possible at the age of 65. If you are not using these funds for health care expenses, you can now start drawing these funds for anything. If you want to take a trip, if you want to do something, if you want to buy groceries, whatever it is, but you lose the tax free withdrawal nature. Keep in mind you still got a tax free contribution and you still got tax free growth. It almost becomes like another IRA for you or 401 pre tax on the way in tax deferral growth along the way. And then when you pull it out, it's taxable. So not ideal if you could use this for qualified medical expenses. But if you're in a situation where you're saying, I've built this thing up to such a large amount that I actually have more than enough to cover all my medical expenses, you could then turn around once you've attained the age of 65 or older and actually use that like you would another ira. Pull the money out. You're not paying any penalties like you would have prior to 65, but you're going to pay taxes on those withdrawals if they're not for qualified medical expenses. Another thing, a lot of times people with a traditional IRA or 401k your investment account, they don't mind building that account for a long time using what they want from it, knowing that their beneficiaries are ultimately going to inherit that. That's not the case with the hsa. This is an account that you do want to make sure, ideally you are fully utilizing by the time that you and or potentially a spouse pass away. Here's how those rules work. If I were to pass away, my spouse would inherit my hsa. It would simply become hers, very much like an ira. If I pass away, my spouse inherits my ira. If myself and my spouse pass away, or if I wasn't married and my children inherited my hsa, the HSA balance is fully taxable to them the year that they inherited. So it's not a great account to do some legacy planning, some beneficiary planning. It's a great account to protect you. And if you're married to spouse, but don't keep building this account up forever, getting addicted to the tax benefit, saying this is $300,000, $400,000, $500,000, at some point that's actually going to be a counterproductive strategy because if you're not using it, your children or your heirs, if it's a non spouse heir, they won't get the same tax benefits you will. It will all become taxable to them when they inherit it. Another thing to quickly mention that goes along with that is once you are enrolled in Medicare, you can no longer make new HSA contributions. You can still of course, maintain your existing HSA balance. It can keep growing, you can still take out distributions from that, but you cannot make new contributions to that account. So where do HSAs fall into the big picture? Grand scheme of things. As I mentioned before, if you don't have a high deductible health care plan, they don't pertain to you at all. This isn't something you have the ability to contribute to. If you do, I like to think of an order of operations of where should you start when it comes to investing your funds. First, if you have a 401k with a match, take full advantage of that. That's free money. That's an automatic return on investment that you're getting. Make sure that you're doing that first. After that though, the HSAs are probably the second thing I'd want to look at. In general, there's of course nuances and it depends upon your situation. But if I'm looking through a checklist, so what am I looking through first? After your 401k match, these can potentially become the next most impactful things that you can invest in, assuming you're eligible. So understand the HSA maybe the least appreciated and most effective type of tax planning tool you have. When you factor in tax free contributions, tax free growth, and then tax free qualified withdrawals. The combination of those three things, along with some of the other things that we talked about today can be incredibly powerful when it comes to planning for a very tax efficient retirement. Root Financial has not provided any compensation for and has not influenced the content of any testimonials and endorsements shown. Any testimonials and endorsements shown have been invited, have been shared with each individual's permission, and are not necessarily representative of the experience of other clients. To our knowledge, no other conflicts of interest exist regarding these testimonials and endorsements. Hey everyone, it's me again. For the disclaimer, please be smart about this. Before doing anything, please be sure to consult with your tax planner or financial planner. Nothing in this podcast should be construed as investment, tax, legal, or other financial advice. It is for informational purposes only. Thank you for listening to another episode of the Ready for Retirement podcast. If you want to see how Root Financial can help you implement the techniques I discussed in this podcast, then go to rootfinancialpartners.com and click Start Here, where you can schedule a call with one of our advisors. We work with clients all over the country and we love the opportunity to speak with you about your goals and how we might be able to help. And please remember, nothing we discuss in this podcast is intended to serve as advice. You should always consult a financial, legal or tax professional who's familiar with your unique circumstances before making any financial decisions.