Sequential Saving

I love Health Savings Accounts (HSAs). There is really no reason not to love the HSA. In the last few posts we have been asking the question “where should I allocate my monthly savings?” This question is best answered in sequence by starting with the most important items such as paying down high interest debt, establishing an adequate emergency fund, and fully funding an HSA. Think of a physical building. No matter how beautiful and grand the building is, if the foundation is not strong a storm or earthquake will bring it crumbling down. These initial steps are about establishing a strong foundation so that an unexpected future event will not crumble your entire personal finance building. As your savings capacity grows and a firm foundation is established, we will begin to discuss 401(k)s, IRAs, 529 plans, and last (and least) plain ole taxable brokerage accounts. It looks something like this.

  1. Initial Emergency Fund and Debt Payoff Planning
  2. Fully Funded Emergency Fund
  3. Health Savings Account
  4. Employer Retirement Plans – 401(k)s and 403(b)s
  5. Individual Retirement Accounts (IRAs) & 529 College Savings Plans
  6. Taxable Brokerage Accounts

The importance of sequential savings outlined above is that it contradicts instinct. For many savers, instinct is to open a taxable brokerage account and begin investing, but this is in fact the very last place you should be allocating savings. So, why is the HSA so high on the priority list?

Why is the HSA so Important?

Individuals can only make HSA contributions if they have a high deductible health insurance plan (HDHP). If you nor your spouse have a health insurance plan that allows for HSA contributions and your employer does not offer a HDHP, what follows will not apply to you.

1) Medical Emergency Fund

The HSA is nothing more than a medical emergency fund with an extra dose of tax benefits. Due to the rising cost of health care, more plans are increasing deductibles and max out-of-pocket levels for participants. This unfortunate change drastically increases the financial impact of a medical emergency on a family. A family HDHP in 2020 can have up to a $13,800 max out-of-pocket according to the IRS. $13,800 of unexpected medical bills would seriously impact many families who do not have an adequate medical reserve. The largest weakness of the HSA is the low contribution limits which place even more importance on getting started as soon as possible.

2020 HSA Contribution Limits

Under Age 5555 or Older
Single Coverage$3,550$4,550
Family Coverage$7,100$9,100

2) The Tax Benefits

Health Savings Accounts are the most tax advantaged account that exists. There are really four levels of tax savings.

  • Contributions are not subject to payroll tax1
  • Contributions are income tax deductible
  • Earnings are not taxable
  • Eligible distributions are not taxable

The below table demonstrates the tax differences between retirement accounts and HSAs in a 22% marginal tax bracket. This example assumes a family is looking to contribute $5,0002 to one of the following accounts.

Comparison of Tax Preferenced Accounts

Traditional IRA/401(k)ROTH IRA/401(k)HSA
Expected Growth before Distribution$1,000$1,000$1,000
Income Tax Savings on Contribution$1,100-$1,100
Payroll Tax Savings on Contribution--$383
Income Tax Savings on Distribution-$1,320$220
Total Tax Savings$1,100$1,320$1,703

3) Flexibility

The HSA is also the most flexible tax advantaged account that exists. The list of eligible HSA uses might surprise you including: Medicare premiums, contact lenses, contact solution, eyeglasses, and over the counter medicines. In addition, after an HSA is opened, any eligible medical expenses incurred and paid outside of the HSA can be reimbursed from the HSA. So, if you incurred a $300 medical visit but only had $15 in your HSA, you can pay the $300 bill personally and then on a later date fund the HSA with $300, take the tax deduction, and reimburse yourself $300 right back out of the account.

It is important to note that HSA distributions for non-qualified expenses before age 65 are subject to a 20% penalty so be sure to double check the eligibility of the expense and keep good receipts and records.

Regardless of Age of Life Cycle

Bo is a recent college graduate and 24 years old. He has signed up for the HDHP with his employer and opened an HSA. Bo has the opportunity to start early and build an HSA balance before future medical expenses such as maternity expenses, newborn doctor visits, and dental braces start to come in faster than he can fund an HSA. Bo decides to fully fund his HSA and begin building his medical emergency fund with $3,550 each year and uses a platform that allows him to invest his account balance due to his long-term time horizon.

John and Cara are 55 years old and have successfully graduated each of their children out of the home and off their pocketbook. John and Cara are covered by John’s family HDHP at work and are tempted to not make any HSA contributions now that the kids are on their own. However, recognizing that projected future medical expenses for a 65-year-old couple in 2019 is $295,000, John and Cara decide to fully fund their HSA for the next 10 years and invest the balance in hopes of never needing it.

The Power of the HSA

The HSA needs to be the number one fully funded account for those on a HDHP with an adequate emergency fund. These accounts serve as a medical emergency fund with great tax benefits and flexibility. Many of the HSA platforms now offer low cost investment opportunities for savers with extra HSA dollars and no short-term expected need. Take a look at your annual savings and see if you can keep from letting a year go by where you do not take full advantage of these low contribution levels.

1 In order for contributions to HSAs to avoid payroll tax they must be deferred through payroll. Contributions can also be made directly to HSA accounts by the account holder, but these direct contributions do not generate payroll tax savings.

2 To correctly make the traditional IRA vs ROTH IRA contribution decision you should tax adjust the contribution amount. A $5,000 traditional IRA contribution is equivalent to a $3,900 ROTH IRA contribution because $1,100 of income tax must be paid on the $5,000 ROTH IRA contribution. In reality, I find individuals set their mind on a contribution amount and then look to the various accounts and do not tax effect their contributions making the above comparison reasonable.