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Should I Invest Money in My HSA Account?

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A Health Savings Account, or HSA, is a tax-advantaged way to save money for health care costs. An HSA account is different from a Flexible Savings Account, or FSA, that many people are more familiar with. For most people with qualifying health insurance plans, an HSA is better than an FSA.

HSA Investing

One of the advantages of a Health Savings Account is that the money does not have to be spent in a single year. Instead, those funds can be left in an HSA for years. In fact, that money can be invested, just like with a 401k plan, or a 529 plan, in order to grow for future medical costs. But, does it make sense for YOU to invest money in your Health Savings Account?

Money that is invested in an HSA grows tax-differed, just like in an IRA or 401k. That many can also be withdrawn tax-free, if and only if, it is used to pay for medical expenses.

There are several factors that determine whether it is a good idea to invest your HSA funds, or whether you are better off leaving them in the cash, or money market account.

How You Use Your HSA Determines If Investing in HSA Is Smart

While all HSA accounts have the same basic structure, there are actually several ways to use them.

The first, and most common way, to use an HSA account is to simply route funds into, and out of, it, in order to pay your current medical expenses. Although this isn’t the main intent of the account, there is no minimum amount of time funds must sit in your account in order to be used to pay medical expenses. In fact, so long as the account is already open when expenses are incurred, you can actually deposit money after the fact, and use it to pay medical bills.

For example, let’s say you found out that you needed strabismus surgery. You could talk with the office manager at the eye doctor’s office and find out that your out of pocket expense would be $813. Then, you would deposit $850 into your HSA from your checking account. When it comes time to do your taxes next year, you’ll get an above the line tax deduction for the $850. (Note: The amount you contribute is the amount you deduct. The amount you withdraw is irrelevant for your taxes, so long as it was used to pay qualified medical expenses.)

You go have the surgery, and when you get the bill a month or two later, you pay it, and reimburse yourself $813. (Some HSA’s have a debit card you can use for payment as well. I prefer to use my own Capital One Rewards points credit card to get the points, or miles, and then have the HSA money deposited into my checking account.)

If this is how you use your HSA account, then there is really no point in investing the money. A drop in the market might leave you short for your bill, and a rising market wouldn’t increase your balance enough for it to be worth it.

The second way to use an HSA account is to just regularly put money into it whether you have any medical expenses or not. This is not unlike an IRA, 529, or 401k plan. You will need the money for some future medical expense eventually. In the meantime, every contribution is a deduction off of your taxes. In this case, once you’ve built up a big enough balance (at least few thousand dollars), you could start investing in an index fund of your choosing.

Obviously, this second method works best for those with excess income to be saving and investing. Putting money like this into your HSA account should come AFTER you’ve already funded your 401k, IRA and 529 college savings plans.

How To Start Investing for HSA

The tricky situation is the scenario in between the above. What if you are putting some money into your HSA, and you have some potential medical expenses coming?

In this case, you still want to build up a balance before investing. Then, the best move is to keep a balance that covers your annual out of pocket maximum, or less conservatively, your annual deductible amount. Everything above this could be invested.

For example, if your policy has an out of pocket maximum of $3,500 and a deductible of $2,500, you could choose to keep $3,500 (more conservative) or $2,500 (less conservative) in cash and invest the amount above that. This essentially gives you a year to plan around any unforeseen expenses before having to dip into invested funds.

Don’t get too clever in your HSA with your investments. Unlike retirement accounts that allow you to reap the rewards of huge returns for any purpose, HSA accounts stay as a medical expense reimbursement account only for your whole life.

This article is for informational purposes only, and should not be considered investment advice, or financial planning advice. The author is no longer a financial planner, and does not hold himself out to be one. For specific advice consult your tax and financial planning professionals.

Procedure for Using HSA Account To Pay Medical Expenses

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I’ve written a bit lately about Health Savings Accounts, or HSAs, how HSAs work with state taxes, and the difference between Health Savings Accounts and Flexible Spending Accounts. But, the one question I keep getting is how exactly to use a HSA account.

The Health Savings Account Theory

The idea behind a Health Savings Account, or HSA, is a little bit like a 401k account, or even a 529 college savings plan account. You save money for future expenses like college or retirement, but in the case of an HSA, you are saving for medical expenses. Like with a 401k plan, or an IRA, you get a tax deduction benefit for making contributions. Also, like the other accounts, your money grows inside the account tax free. And, finally, like a Roth IRA, or a 529, you withdrawals for approved expenses are also tax free.

So, theoretically, assuming the world around you proceeded in an orderly and predictable manner, and your budget contained plenty of room for all appropriate spending and savings, then you would contribute regularly to your HSA account, and invest that money, so it could grow over time, into a big reserve that is available to you when you have medical issues down the road. If you are familiar with studying physics, you may remember that in basic physics all the equations work, as long as you are on a frictionless plane, in a vacuum. This is kind of the same thing, for medical finances.

If this doesn’t sound exactly like your life, don’t worry; most people don’t live like that either.

What makes the HSA very different than those other retirement and education accounts is timing. Your child is 10 years old now, they will go to college in eight years. You have no reason to use any of the 529 money between now and then. Likewise, you are 20 years from retirement, so there is no reason to withdraw any money from your IRA or 401k either. Yes, things could change, maybe Junior gets into college a year early, or maybe things go your way and you retire in 15 years, but either way, there is a built in time frame to those accounts. In fact, if you did try and withdraw any of that money sooner, there may be stiff tax consequences.

Medical expenses, however, are not like that. You might need to go the doctor next month, or even tomorrow. In fact, there is a very good chance that you’ll need to withdraw and use money from your HSA account at least once in the next 12 to 24 months. That makes using an HSA unusual for most people.

Using HSA Reality

So, how should you use your HSA in reality?

First, you have to setup an HSA account. Everything starts when you OPEN your HSA account. If you open your HSA on June 1st, and you have medical expenses on June 2nd, you can use HSA money. But, if you open your HSA on June 1st after visiting the doctor on May 31, you can’t use HSA funds for that May visit. So, the most important thing is to open your Health Savings Account as soon as you qualify for it, even if you don’t put any money in it right away!

Second, you have to put money into the HSA. Typically, you can either setup some sort of salary reduction, where money from your paycheck gets directly put into the HSA, or you can link a checking account and transfer money into the HSA, either on a regular basis, or as needed.

Here is where it gets a bit confusing. Many HSA accounts come with a debit card that you can use to pay for your medical expenses. This is great, and it helps with record keeping, however you do not have to use that debit card at all. It is only for convenience. You can actually pay your expenses any way you like — check, credit card, cash — and then reimburse yourself from the HSA account.

What throws people off is that while using the debit card is just like a checking account debit card (you have to have sufficient funds), that functionality has nothing to do with the tax advantages. The tax benefits come solely from the contributions you make to the account. In other words, you get a tax deduction for every dollar you put it, up to the HSA contribution maximum for the year. This is the only thing that matters on your Form 1040, is how much money you put in. You don’t report the money coming out.

How To Withdraw From Your HSA

You do not report the money you withdraw from an HSA to the IRS. And, unlike a Flexible Spending Account (FSA) the company that holds your HSA account won’t require any sort of receipt, or proof, either. You will only need proof if you are audited. Otherwise, no one need cares.

So, how do you actually use your HSA?

The easiest way is to just use your HSA debit card to pay your medical bills, but it isn’t the only way, or even the best way, depending upon your circumstances.

The other way is to pay your bills some other way, and then reimburse yourself. So, perhaps you write a check or use some MasterCard or Visa that you get credit card airline miles or rewards points for. To reimburse yourself, you can either withdraw the money from an ATM using the debit card, or send the money directly to your linked checking account. Your HSA may also provide you checks which you can write to yourself. As long as the total amounts match up over the year, it doesn’t matter how you put the money in and out.

In a lot of ways, this can end up looking like legalized money laundering.

For example, let’s say you open your HSA account on March 1st. On March 5th, you go to the doctor. On March 20th you get a bill for $95. You pay the $95 by mailing in a check. Then, on March 30th, you get paid and $100 comes out of your paycheck into your HSA. On April 5th, you use your HSA debit card to take out $95, and you go to the movies. — That’s all fine. You deduct the $100 contribution, and since there was an allowable $95 medical expense, there are no taxes or penalties on the withdrawal, even though the money didn’t go directly to the doctor.

It can get even stranger. Imagine you have an HSA account open. It has a balance of $50. You fall and go to the emergency room on March 10th. The bill comes to $1300. On March 15th you use your connected checking account to transfer $1300 into your HSA. You wait a few days for the transfer to complete, and then you pay the $1300 bill by calling the billing department and giving them your debit card number over the phone. — That’s fine too. Again, the contribution is what matters. You get to deduct $1300 for making a contribution during the year. It is irrelevant that the contribution was made after the medical expense was incurred. And, the withdrawal is tax-free because you had $1300 in eligible medical expenses, even though they occurred before the contribution was made.

You cannot, however, reimburse yourself for any expense that occurs before your HSA is open, even if you are eligible for an HSA, so open your account, right away.

The key thing to remember is that the money you put IN is your tax deduction. The money you take out does not affect your taxes, so long as it is less than or equal to your medical expenses. You must keep the receipts to prove the amount of the expenses in case you are audited, but no one will ask for them until then.

So, to maximize your deduction, make sure every medical expense you have is either paid from, or reimbursed by, your HSA account, even if you have to put money in after the expense is incurred to do so. Do that, and you’ll maximize your deduction for HSA contributions, which is much better than only getting to write off whatever medical expenses you have above the 10% medical costs deduction.

Health Savings Accounts State Taxes

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We’ve discussed before how much of a benefit a Health Savings Account, or HSA, can be for saving money on your taxes. Contributions to an HSA are tax deductible for federal income tax purposes, or in the case of pre-tax contributions, they are simply not part of your income for federal income tax purposes. In addition, all interest, or capital gains earned within an HSA are tax-free, assuming all withdrawals are made to pay qualified medical expenses.But, what about state taxes on Health Savings Accounts?

State Taxes on HSA Accounts

The Federal Government can’t force states to do things, although there are ways around that, such as make your drinking age 21, or you get less federal highway funds. So, the various states don’t necessarily have to go along with the Feds when it comes to what is and is not tax deductible.

In some states, however, that just happens by default. For example, in Colorado, the state income tax form is based upon the taxable income that you calculate for your federal income taxes. In other words, if you deducted it on your U.S. income taxes, it is already deducted when you start doing your state income taxes. That isn’t how every state works, however.

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When it comes to Health Savings Accounts, however, most states play ball.

Most states do not tax contributions or earnings on Health Savings Account funds, just like the Feds. There are also nine states without any income taxes at all, so obviously they do not tax that contributions either.

However, there is always an exception. Three states tax contributions to HSAs in one way or another: California, Alabama and New Jersey.

There are two states that do not tax the contributions, but do tax earnings. That is New Hampshire, and Tennessee.

If you live in any of these five states, you’ll need to do some research to find out exactly what and how your HSA dollars might be taxes. Everywhere else though, your contributions save you even more money by also being deductible on your state income taxes.

Which Is Better HSA or FSA?

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Which is better a flexible spending account or a health savings account?

The answer to which is better between a health savings account or flexible spending account depends, unfortunately, on the specifics in which they are setup. However, it is relatively simple to determine which is better an FSA or an HSA.

First, you’ll want to understand what an FSA vs an HSA looks like.

When FSA Is Better Than HSA

An flexible spending account, or FSA has many advantages over paying for medical expenses out of your own pocket. However, it has only one real advantage over a health savings account, or HSA. The only eligibility requirement for having and using an FSA is that your employer offers one. It doesn’t matter what kind of health insurance plan you choose, or whether that plan has a high deductible.

In order to have an HSA, you must have a qualifying high-deductible health insurance plan. The reality is that the deductibles aren’t necessarily that high, and in fact, may be close to the deductibles on other health plans. But, if you don’t qualify for an HSA, then a FSA is better than an HSA.

The only other advantage of an FSA is that generally, the whole balance of your account is available to you immediately, even if you haven’t made all the contributions yet. In other words, if you setup a salary deduction of $2,400 for the year, you can use the whole $2,400, even if it has only been four months, and you’ve only contributed $800. (The rest will be paid back by your deferrals over the course of the year.)

The only other advantage of an FSA is recording keeping. With an FSA, you submit claims with receipts to get reimbursed for your expenses. With an HSA, you just use the money. If the IRS ever comes asking, you have to have receipts to prove that you spend the HSA monies on medical expenses. So, it’s a lot easier to get your money from an HSA than an FSA, but you don’t have to keep the records once they are submitted for an FSA.

Some banks offer record keeping as part of the HSA account.

When HSA is Better Than FSA

If you qualify for a health savings account, or HSA, then an HSA is better than an FSA in almost every situation. The only time that won’t be true is if your employer has done a poor job of setting up your options.

There are three major differences between an HSA and FSA, and they favor the HSA in most cases.

First, an HSA balance is yours to keep forever. An FSA must be used during the same year contributions are made, with a possible 2 1/2 month extension, but only if your employer allows it. An HSA balance can be carried over from year to year.

HSA Balance If You Change Jobs or Health Plans

One concern some people have is what happens to your health savings account (HSA) if you quit, change jobs, or change health insurance plans. The answer is nothing.

An HSA account is your own account, in your own name, much like an IRA account, or even your 401k account. If your circumstances change such that you no longer qualify for an HSA, then you can no longer make contributions. You can, however, continue to spend any money that is already in the account.

Contributions are made pretax, and this is a huge advantage, however, pretax contributions can also be made to an HSA if your employer allows it. Even if not, HSA contributions are deductible above-the-line, so the net result for almost everyone is the same when it comes to your income taxes.

HSA Contributions

How to make HSA contributions can also be an enormous advantage over how you make FSA contributions. Flexible spending account (FSA) contributions must be made by salary deduction. You also have to decide how much to contribute for the entire year before the year starts, usually during your open enrollment period. In other words, you literally have to guess how much money you will need. Guess to high, and you’ll be trying to spend down your account at the end of the year. Guess too low, and you’ll run out of money and have to pay your expenses without any tax-advantages at all.

Some employers offer to make pretax contributions to your HSA. These contributions will be the same, as above. However, many HSA accounts allow additional, ad hoc, contributions at any time. The advantage is that you can contribute when you know expenses are coming.

For example, with an FSA, you have to estimate your expenses. Perhaps you plan for six doctor visits, some prescription drugs, and your monthly chiropractor visits. Once that number is set, it cannot be changed.

Now, if four months after open enrollment, you find out that you need a minor surgery, like hernia surgery, or something with the eyes, or whatever you like. That extra expense was unplanned, and you’ll have no way to pay it with pretax salary deductions. But, with an HSA, you can make an extra $1,000 (or whatever amount) at anytime. Make the contribution in March, have the surgery in April, and pay the bills when the start arriving in May, all with money that will be an above the line tax deduction.

It’s like being able to deduct all of your medical expenses, without having to make the 10% threshold. Plus, the deductions occur above the line, so they lower your adjusted gross income for things like the child tax credit, IRA destructibility limit and other tax deductions, credits, or phaseouts tied to your income.

HSA Contribution Limits 2016 and FSA Contribution Limits 2016

Both medical savings accounts limit how much you can contribute each year.

For 2016 HSA contribution limits are $3,350 for an individual, or $6,650 for families.

The 2016 FSA contribution limit is $2,550 per FSA account, which is much lower, especially for families.

What Expenses Can HSA and FSA Cover?

This is one area, where comparing HSA and FSA is easy. Both accounts use IRS Publication 502 to determine what an eligible medical expense is. In other words, the two plans are the same. If you can use an FSA to cover something, then you can use an HSA to cover it as well.

You Can Invest HSA Money

Frankly, as a former financial advisor, I would tell you not to bother investing your HSA money. You never know when you will need it, and liquidating funds during a downturn could leave you with much less money that you contributed.

Instead, invest extra funds elsewhere, a Roth IRA if you want tax advantages, a regular brokerage account if not. Typically the small amounts here won’t be worth investing. Unlike an IRA account where the small annual investments will grow untouched for decades, the money you invest here will flow into and out of the account as you use it for your medical expenses.

In short, the HSA is better than an FSA for most people, assuming you have the health plan to qualify for it. If you prefer a different health plan, or have no other choice, then use the FSA. It’s almost as good, and still much better than paying for medical bills without any tax advantage at all.