The Stealth IRA: Health Savings Account

WHAT IS AN HSA? 

An HSA (not to be confused with an FSA, flexible spending account, which is completely different) is a tax-advantaged investment account where, similar to a retirement account, money is deposited and you can choose funds to invest your money in. It's for getting tax benefits for health-related expenses. The yearly contribution limit is $8,550 per family, and it can only be created if you aren't on Medicaid. 

The Benefits of an HSA 

An HSA actually has triple tax benefits. Let's illustrate this by contrasting it with two common tax-advantaged accounts that don't have as many benefits. 

Money deposited in a traditional IRA is tax-deductible, and the growth of the investment is tax-deferred, but there are drawbacks. When you start to withdraw the money, taxes need to be paid as income for the year withdrawn. In addition, once you reach a certain age, there are required minimum distributions (RMDs). You can't leave all the money there to grow on a permanent basis. 

A Roth IRA, on the other hand, is for after-tax dollars, so it doesn't have the benefit of lowering your income, but the money is tax free when you start withdrawing. Roth 401(k) plans and 401(k) plans work the same way. 

An HSA is different. While many people use it to pay their yearly medical expenses (which is still good for a tax deduction), most people don't realize that an HSA can be easily used as a retirement account and is often referred to as a "stealth IRA." If you regularly withdraw money from your HSA to reimburse yourself for medical expenses, you're missing out on the best retirement account, since its tax benefits are better than those of a 401(k) or IRA. Why? It can be funded with pretax dollars, thereby lowering your income, and there are no taxes on the growth or on the withdrawal. So it has triple tax benefits compared to other options' two. 

The Catch

The catch is that until age 65, the money can only be used for medical expenses. However, you don't need to withdraw the money to pay the medical expenses when you are billed. You can use it like a retirement account and pay for all your medical expenses out of pocket, as long as you have medical expenses sometime in your life equaling the funds in the account. You do need to hold onto your medical receipts so if the IRS questions what all the tax-free withdrawals are for, you can show that they're to reimburse yourself for the last 30 years' worth of medical expenses. 

Medical expenses add up. When figuring out how much money to invest, calculate the amount of medical expenses you might have. It may be more than you assume at first glance. Although you can't contribute when on Medicare-which many people are when their medical expenses get high-you can still use the money that was put in. So if Medicare won't payfor an aide or a nursing home, the money invested in the HSA account can potentially be utilized for that purpose. 

Additionally, once you reach the age of 65, you can withdraw the money for any purpose, but it will count as income when you file your taxes, just like money that was put in a traditional IRA. Therefore, if a Roth IRA is a better fit for you than a traditional IRA, don't put more than you think you'll need for medical expenses into your HSA. But even if you do, it won't be worse than if you had used a traditional IRA. 

Eligibility 

You can only contribute to an HSA account if you have a high-deductible insurance plan, so if you have Medicaid, for example, you're not eligible. Having a high deductible is usually a good idea if you pay for health insurance, as it lowers the monthly premiums. The deductible needs to be at least $3,300, and the annual out-of-pocket maximums you can use it for, such as copays, but not including premiums, is $16,600. When purchasing insurance, run the numbers with an agent to see if an HDHP makes sense for you; eligibility for an HSA will also be a factor in what plan to choose. 

There are also other rules regarding eligibility and inheritance, for example, that you should look into when determining if it makes sense for you and how much to fund it with. While it's still a great opportunity, in a few states such as New Jersey, HSA tax benefits only apply to federal taxes, since they are not given special tax regarding state taxes.

Order of Operations

Should you fund an HSA in place of your IRA/401(k)? In general, the best retirement account to fund first is a 401(k) if there's an employer match. So if your job matches up to 2 percent, for example, of what you contribute, prioritize contributing 2 percent of your income to your 401(k). For example, if you make $100K a year, contribute $2,000, and it will be matched by your employer and immediately become $4,000. It's doubling your money immediately, risk free - one of the best deals possible in personal finance. However, only fund it up to the match to get the match. Afterward, there's no match benefit, so it's just a regular 401(k), and an HSA, with triple tax benefits, is better. Once your HSA is fully funded for the year or if you're not eligible for one, then fund your IRA, which is usually better than a 401(k), as there are often more options of funds to invest in. Once that's done, return to your 401(k) and max it out if possible, since a 401(k) is still better than a taxable investment account.

(You may not be able to take a deduction from a Traditional IRA contribution if you have to a 401(k), so research if applicable.)

Obviously, this level of investment in retirement accounts is prob-ably above most people's ability, but it's important to remember your order of priorities when investing in a retirement account.