This article shows how clients can benefit from viewing a health savings account (HSA) as a flexible tax-favored investment strategy. HSAs allow taxpayers of any income level to deduct contributions immediately and withdraw the contributions, with accumulated investment earnings, free of tax at any age. That is, the “health” moniker can be a misnomer by disguising a key benefit of an HSA: An HSA can be a flexible tax-favored investment vehicle.
Compared with more aptly named individual retirement accounts (IRAs), an HSA savings strategy (1) allows tax-deductible contributions like a traditional IRA but without its limitations on working alongside a Sec. 401(k); (2) allows tax-free withdrawals like a Roth IRA and without its income-based contribution limits; and (3) avoids waiting until retirement age for penalty-free withdrawals of earnings, as required by both traditional and Roth IRAs. This short article explains that U.S. tax law currently permits this tax-favored investment strategy by effectively combining the tax benefits of an HSA with an investment strategy.1
Sec. 223 allows a taxpayer covered by a qualified family high-deductible health plan (HDHP) to make deductible contributions to an HSA trust account of up to $7,300 in 2022 or $7,200 in 2021 (for taxpayers with a qualified self-only HDHP, $3,650 in 2022 and $3,600 in 2021). An additional $1,000 deduction is allowed for taxpayers who are at least 55 years old at any time during the tax year. Employer contributions made to an HSA are excludable from the employee’s gross income (Secs. 106(d) and 125). The employer contributions to the HSA also reduce the annual limits on the employee’s deductible contributions. An HSA remains with a taxpayer after he or she leaves an employer or the workforce entirely, which adds portability to the benefits of an HSA.
Withdrawals from an HSA to cover the costs of qualified medical expenses as defined in Sec. 223(d)(2) are tax-free, including withdrawals of investment earnings on the HSA funds. Employees can direct the HSA administrator to pay for qualified medical expenses directly from the account. Indeed, some plans provide HSA participants with debit cards to pay these expenses directly, which can help the taxpayer meet the substantiation requirements. Regardless of how medical costs are withdrawn, the taxpayer is responsible for documenting that the funds are used exclusively to pay for qualified medical expenses, that the expense has not previously been reimbursed or paid for by another source, and that the medical expense is not also included among itemized deductions.
An alternate approach — the strategy recommended here — is for the taxpayer to pay the medical bills personally and request reimbursement of these costs from the HSA only when he or she needs the funds. Of course, a taxpayer should carefully document each medical expenditure and carefully preserve this documentation. However, there is no time requirement for requesting reimbursement from the HSA. Therefore, a valid tax strategy is to pay medical costs from non-HSA funds, retain the reimbursement documentation, and wait until the funds are needed to obtain reimbursement for the costs. Note, however, this strategy is only useful to the extent that the taxpayer can afford to pay the medical expenses from sources outside the HSA. This approach is valid because no time limit prescribes when a qualified medical expense claim must be filed.
The ability to use an HSA as a tax-favored investment vehicle depends on two things. First, when a medical bill falls due, the taxpayer must be capable of paying it with funds outside the HSA. The investment benefit decreases as the taxpayer draws on the HSA funds. Second, taking tax-free withdrawals depends in part on the taxpayer’s incurring medical costs that can be reimbursed from the HSA upon submission of receipts. Since some taxpayers and their families are relatively healthy, their health decreases the flexibility of the HSA as a tax-favored investment vehicle from which funds can be drawn upon quickly and without penalty. However, even healthy taxpayers face regular health and dental expenses, which include unprescribed over-the-counter medicine and menstrual care products, that qualify for reimbursement. To the extent that a taxpayer pays these costs out of pocket and can substantiate they were paid, these paid but unreimbursed costs allow the taxpayer to later draw on his or her tax-favored investment as needed. One way to view paying qualified medical expenses with non-HSA funds is that these payments become highly flexible, heavily tax-favored investments. Of course, if non-HSA savings or after-tax investments are not available to pay medical costs, HSA funds can be used. But using HSA funds to pay qualified medical expenses should be a last resort, not the default strategy.
Examples of applying the strategy
Example 1: M (age 25) and J (age 24) married in 2021. M works for a large public accounting firm, and J freelances as a graphic design artist. Starting in 2021, each year, M’s employer pays the cost of family HDHP coverage and contributes $2,000 to M’s HSA. In addition, M and J annually contribute $1,000 to the HSA and claim a deduction for this amount on their joint tax return; this $1,000 pretax contribution is considerably smaller than would be required for traditional full-coverage health insurance. The net annual cost is $700 after considering their 30% marginal tax rate. M and J are in good physical condition, but annual vision, dental, and menstrual care; wellness checks; and over-the-counter medicine costs total $2,500 per year, which M and J carefully document and pay out of pocket without requesting reimbursement from the HSA. The HSA funds are invested and earn 8% annually.
The couple buy a house in 2027 after having a baby in 2025.The couple planned and paid for the $6,000 cost of having the baby out of pocket, including prenatal care and two hospital nights.2 By 2027, the balance in the HSA has grown to $27,839, which includes $6,839 of tax-free income. In 2027, the couple submit reimbursable receipts that total $23,500, the proceeds of which finance a portion of the down payment on the house. 3
Example 2: B (age 51) and G (age 47) are empty nesters at the beginning of their high-income years and begin considering the heavier medical costs that are likely to come with getting older. B is a successful self-employed consultant who earns approximately $300,000 annually, an amount that trends upward a bit each year. Starting in 2021, they switch to an HDHP and begin contributing (and deducting) the maximum per year, which is $7,200 and is assumed to increase $100 per year; they add $1,000 per year to their contributions when B turns 55 in 2025. Annual reimbursable medical costs from 2021 to 2035 begin at $3,500 and increase by $200 per year; these costs are paid out of pocket, but the receipts are carefully maintained. The HSA funds are invested and earn 8% annually.
Just before B retires, shortly after reaching age 65, they buy a second home in an active retirement community. Part of the down payment for the home is the $73,500 supported by medical receipts that they withdraw tax-free from their HSA. After the withdrawal, $162,924 remains in the HSA earning 8% annually. These funds can be withdrawn tax-free to pay premiums for Medicare Part A, B, C, or D coverage and long-term health care costs.4
Quantified benefits of the strategy
Let us assume that in December 2021 a taxpayer receives a $1,000 medical bill for a recent outpatient procedure. She maintains an HDHP and possesses both a $5,000 balance in her HSA and sufficient after-tax investment funds with which to pay the bill. She expects the same risk and return from the HSA investment that she would obtain from the non-HSA investment. Let us compare the 10-year after-tax effects of two ways of using the HSA: (1) paying the $1,000 medical bill personally, requesting reimbursement of the $1,000 from her HSA, and investing the $1,000 reimbursement check outside the HSA, and (2) paying the $1,000 medical bill using existing after-tax investment funds that do not require gain recognition to access, and leaving $1,000 invested within the HSA with annual earnings realizations.
Table 1 (below) shows the results of this comparison across three possible pretax rates of return (2%, 6%, and 12%). In the table, the investments (either inside or outside the HSA) are assumed to produce interest or short-term capital gain income that is reinvested annually and, if invested outside the HSA, are subject to two possible marginal tax rates (20% and 40%).
Table 1, Panel A, shows that, facing a 20% marginal tax rate, after 10 years, the investment outside the HSA increases in value by 17.2%, 59.8%, and 150.1% with respective annual pretax returns of 2%, 6%, and 12%. However, if the funds are invested within the HSA, the 20% annual tax does not apply. Thus, the annual pretax returns of 2%, 6%, and 12% are the after-tax returns. At 2%, 6%, and 12%, the 10-year cumulative after-tax returns are 21.9%, 79.1%, and 210.6%, respectively. If the only difference between investing outside the HSA and inside the HSA is the 20% annual tax on investment earnings, a $1,000 investment within the HSA will produce cumulative 10-year returns that are 4.7, 19.3, and 60.5 percentage points greater than an investment outside the HSA, given pretax returns of 2%, 6%, and 12%, respectively. In Panel B, the marginal tax rate is 40%, and the additional after-tax benefit of investing within the HSA nearly doubles to 9.2, 36.7, and 110.2 percentage points across the respective 2%, 6%, and 12% pretax returns.
Table 2 (below) shows comparable figures to Table 1, except that the underlying investment produces taxable gain only at the end of the 10-year period. The capital gains tax rate for the investment outside the HSA is assumed to be 15% in Panel A and 30% in Panel B. For example, in the first column of Panel A, the $1,000 investment that earns 2% compounded annually produces a pretax investment value of $1,218.99 (i.e., $1,000 × (1 + 0.02)10). The increase in investment value, $218.99, is subject to 15% capital gains tax ($32.85), which leaves an after-tax investment of $1,186.15 and an after-tax 10-year cumulative return of 18.6%.
If the $1,000 had remained invested inside the HSA at the same 2% compounded annually, it would have produced an after-tax investment valued at $1,218.99 and a 10-year after-tax return of 21.9%, 3.3 percentage points higher than if invested outside the HSA. Assuming pretax rates of return of 6% and 12%, respectively, an investment inside the HSA produces cumulative 10-year investment returns that are 11.9 and 31.6 percentage points higher than an investment outside the HSA. In Panel B, we see that increasing the 15% long-term capital gains tax to 30% doubles the additional 10-year after-tax return from delaying HSA reimbursement to 6.6, 23.7, and 63.2 percentage points across the 2%, 6%, and 12% respective annual pretax rates of return.
Tables 1 and 2 show that funds allowed to remain in an HSA produce greater after-tax returns than funds withdrawn from an HSA and then invested. The differential is widest when the underlying investment produces higher pretax rates of returns and when the taxpayer’s marginal tax rate is greater. Also note that keeping the funds inside the HSA has greater relative tax benefits when the underlying investment produces annual earnings realizations (Table 1) than when it produces end-of-the-investment-period capital gains (Table 2).
Comparing the HSA with a traditional IRA and a Roth IRA
A variety of investments provide tax benefits, including (1) purchasing a security that produces tax-exempt municipal bond interest; (2) acquiring real estate and property that produces tax-sheltering depreciation; and (3) investing in nondividend growth securities that defer gain realizations, among many other possibilities. But for many taxpayers, IRAs are comparable with the HSA. If a taxpayer is familiar with an HSA, she also likely is somewhat familiar with a traditional IRA or a Roth IRA. So, next we compare the features of these tax-favored vehicles, although it is important to note that it is quite possible, and likely advisable, for a taxpayer to utilize both an HSA and an IRA simultaneously.
Some pertinent HSA details: An HSA is available to any taxpayer who maintains an HDHP, who has no other health insurance (including Medicare), and who cannot be claimed as a dependent on someone else’s tax return. For this purpose, an HDHP must meet the requirements of Sec. 223(c)(2), including 2022 maximum annual out-of-pocket expenditures of $7,050 for a self-only plan or $14,100 for a family plan ($7,000 and $14,000, respectively, in 2021). In accord with its high-deductible name, an HDHP must also have 2022 (and 2021) minimum deductible amounts of $1,400 for a self-only plan and $2,800 for a family plan.
Contributions to an HSA are deductible if contributed by a taxpayer or excludable from gross income if contributed by a taxpayer’s employer. However, once a taxpayer begins Medicare coverage, no contributions to an HSA are allowed. For taxpayers who will begin Medicare in the month they turn 65, contributions to the HSA must cease and the taxpayer can only deduct a month-based pro rata portion of the annual HSA contribution limit for that year. Taxpayers should be aware that they can become accidentally enrolled in Medicare when they turn 65 because the Social Security Administration automatically enrolls them or because they work for a smaller employer who automatically shifts medical insurance to Medicare upon reaching their 65th birthday. However, a taxpayer can reject these automatic enrollments, allowing the taxpayer to continue making tax-deductible contributions to an HSA as long as he or she maintains coverage under a qualified HDHP.5
Some employers allow employees to receive some (or all) of their health insurance benefit in the form of contributions to an HSA, which are deductible to the employer and excludable to the employee. Taxpayers without this form of compensation can make their own contributions. Regardless of source, the annual contributions to an HSA are limited in 2022 to $3,650 for an individual self-only plan or $7,300 for a family plan ($3,600 and $7,200, respectively, in 2021), and an additional $1,000 for taxpayers who are age 55 by the end of the tax year.
Withdrawals from an HSA are tax-free if they are used for qualified medical expenses, as defined in Sec. 223(d)(2), that, for expenditures incurred after Dec. 31, 2019, include menstrual care products and over-the-counter medicine.6 A taxpayer must be able to substantiate that the withdrawals were used for qualified medical expenses. Withdrawals from an HSA greater than amounts used for qualified medical expense are taxable, and an additional 20% penalty is applied to withdrawals before the taxpayer reaches age 65 that are not used for qualified medical expenses. The 20% penalty is waived upon the death or disability of the beneficiary. The HSA has no minimum required distributions.
Comparable aspects of traditional IRAs and Roth IRAs: Neither the traditional nor Roth IRA requires health insurance coverage of any kind, and certainly not HDHP coverage. On the other hand, both IRA types require service-related income (“compensation”), while an HSA can be used to reduce any type of taxable income. Contributions to either the traditional IRA or Roth IRA (or both) are limited to the lesser of $6,000 (in both 2021 and 2022) or taxable service-related compensation. An additional $1,000 is allowed for contributions to the IRA account(s) by taxpayers who are age 50 by the end of the tax year, five years younger than the 55 required for the $1,000 addition for an HSA.
Like contributions to an HSA, contributions to a traditional IRA generally are deductible by taxpayers. It is also possible to structure excludable employer contributions on behalf of employees under separate rules for a Sec. 408(k) SEP IRA or a Sec. 408(p) SIMPLE IRA. However, taxpayers with an employer-provided retirement plan (e.g., Sec. 401(k)) can only deduct their IRA contribution if they have modest amounts of income. Specifically, for these taxpayers, the traditional IRA contribution deduction completely phases out in 2022 when modified adjusted gross income (MAGI) reaches $78,000 for single or head-of-household taxpayers, $129,000 for married-filing-jointly taxpayers, or $10,000 for married-filing-separately taxpayers.
Contributions to a Roth IRA are not deductible, in contrast with contributions to both an HSA and a traditional IRA. Also, for Roth IRAs, contributions are generally disallowed for higher-income taxpayers. In 2022, the amount a taxpayer can contribute to a Roth IRA is completely phased out when MAGI reaches $214,000 for a married-filing-jointly filer, $144,000 for a single or head-of-household filer, or $10,000 for a married-filing-separately filer.7
Withdrawals from a traditional IRA are taxable. Furthermore, a 10% additional tax on early distributions applies to amounts withdrawn before the taxpayer reaches age 59½. Withdrawals from a Roth IRA are not taxable and not subject to the 10% additional tax on early distributions if they are made after the taxpayer reaches age 59½ and the taxpayer has had a Roth IRA for at least five years. Withdrawals of contributions to a Roth IRA at any age are not taxable or subject to the 10% additional tax on early distributions. However, withdrawals of earnings from a Roth IRA generally are taxable and may be subject to the 10% additional tax on early distributions unless one of several exceptions applies.
Table 3 (below) compares basic features of traditional IRAs, Roth IRAs, and HSAs as investment vehicles.
Flexibility and tax benefits
Taxpayers with HSAs receive tax and flexibility benefits when they pay medical costs using non-HSA funds. The tax benefit arises because HSA withdrawals are tax-exempt income to the extent that they are supported by receipts for qualified medical expenses. The flexibility arises because the taxpayer can choose when to submit the receipts, accumulating them over time until the taxpayer chooses to make a tax-free withdrawal. Compared with either a traditional IRA or a Roth IRA, an HSA has the advantage that it accumulates tax-exempt income that can be withdrawn at any age, subject only to the requirement that the taxpayer can submit receipts for qualified medical expenses.
1This article only summarizes, compares, and analyzes some of the key features of the HSA, traditional IRA, and Roth IRA tax-favored health and retirement savings vehicles. Other sources should be consulted for complete details, which could include related articles in The Tax Adviser and Tax Insider: Zonneveld, “Health Savings Accounts Can Save Taxpayers Money,” Tax Insider (Oct. 10, 2019); Mindy, “How to Make Sure an HSA Avoids ERISA,” Tax Insider (Sept. 28, 2017); Doerrer and Trotta, “Developing a Solid Approach to Advising Clients on Roth IRAs,” 51 The Tax Adviser 604 (September 2020); and Lott “Roth IRA Planning,” 47 The Tax Adviser 202 (March 2016).
2See Cautero, One Mom Shares How Much It Cost to Have a Baby With an HDHP,” Northwestern Mutual website (Oct. 21, 2020).
5Practitioners should discuss with the clients the possible downsides of not enrolling in Medicare Part A, which are beyond the scope of this article.
6Coronavirus Aid, Relief, and Economic Security (CARES) Act, P.L. 116-136, Sec. 3702, Sec. 223(d)(2).
7It is possible to circumvent Roth income limitations using a so-called backdoor Roth conversion strategy where the taxpayer contributes to a traditional IRA and, by the end of the tax year, the traditional IRA is rolled into a Roth IRA so that no balance remains in any traditional SEP or SIMPLE IRA account at year end. Details of this strategy are beyond the scope of this article.
Jeffrey Gramlich, Ph.D., is a professor of accounting at Washington State University in Pullman, Wash. He is also the director of the Hoops Institute of Taxation Research and Policy. For more information about this article, contact email@example.com.