Your health savings account (HSA) can help you save (tax-free) for medical expenses that health insurance won't cover. But it can also help you build long-term wealth for retirement, which might be a better way to use it.

If you are looking to save money for long-term purposes, don’t overlook the potential of health savings accounts (HSAs) to help. While HSAs are not investment accounts in the traditional sense, you can use a health savings account to create a substantial nest egg that you could use at a later date under certain circumstances.

What is a health savings account?

Established by the US government in 2003, health savings accounts, or HSAs, are generally employer-sponsored savings accounts that enable employees to put aside pre-tax money to cover their medical expenses during the year.

HSAs are often part of employer-sponsored “cafeteria” plans that enable you to participate in certain benefit packages. However, you can also set up an HSA on your own, as long as you do it through a third-party trustee, like a bank or a brokerage firm.

HSAs were created for employees who have high-deductible health insurance plans. In theory, the money in an employee’s HSA will cover any medical expenses they incur prior to meeting their deductible for that year.

Related: Understand health insurance terminology: Deductible, co-insurance and out-of-pocket maximum

Contributions to an HSA can be made by either the employee or by their employer. Employee contributions are similar to retirement plan contributions, in that they reduce the employee’s taxable income, and may be retained in the plan and allowed to grow tax free.

You cannot qualify for an HSA if you are on Medicare, or if you can be claimed as a dependent on someone else’s tax return.

Health savings account contribution limits

Like all tax-favored plans permitted by the IRS, health savings accounts have contribution limits.

The HSA annual contribution limits for 2016:

  • Individuals self-only coverage with a high-deductible health insurance plan – $3,350
  • Individuals with family coverage with a high-deductible health insurance plan – $6,750

Contribution limits apply to contributions made to the plan by both the employee and the employer. So if you are an individual with self-only coverage, and your employer contributes $1,000 to your plan, your contribution will be limited to $2,350.

High-deductible health plan definition

For 2016, a high deductible plan is defined as an annual deductible that is not less than $1,300 and not more than $6,550 for individual/self-only coverage, and a minimum deductible of $2,600 to a maximum deductible of $13,100 for family coverage.

Contribution deadline

You can make a contribution to an HSA up until the tax filing deadline for the previous year. So for 2015, you can make a contribution up until April 18, 2016.

The benefits of health savings accounts

Health savings accounts have four major benefits:

  1. Contributions are tax deductible.
  2. Funds retained in the plan can be invested and allowed to grow on a tax-free basis.
  3. Withdrawals from the plan are tax free if they are used to pay for qualified medical expenses. (If withdrawals are taken for non-medical reasons, the distribution will be subject to regular income tax, plus a 20-percent penalty.)
  4. An HSA balance accumulated with an employer is portable, in that you can take it with you if you leave that employer.

Additionally, the tax-deductible nature of HSA contributions also serves as a workaround for taxpayers to deduct medical expenses. Since medical expenses can only be deducted if you itemize your expenses on IRS Form Schedule A, and that medical expenses must exceed 10 percent of your adjusted gross income (AGI) in order to be deductible, an HSA lets you deduct at least part of your medical expenses through your contributions—even if you don’t use the funds for medical expenses immediately.

How to use your health savings account as a long-term savings account

Considering the second point above—that funds retained in the plan can be invested and allowed to grow on a tax-free basis—a health savings account has the real potential to become a long-term savings account. The tax-free status of earnings on unused funds means that the account can continue to grow in much the same way that a tax-deferred retirement plan can.

As an example, a report from the Employee Benefits Research Institute determined the following:

“A person contributing for 40 years to an HSA could save up to $360,000 if the rate of return was 2.5 percent, $600,000 if the rate of return was 5 percent, and nearly $1.1 million if the rate of return was 7.5 percent, and if there were no withdrawals.”

These figures, as impressive as they are, are admittedly based on very optimistic projections. For example, they make the assumption that the account will be in existence for 40 years, that you will make the maximum allowable contribution each year, and that you will never take any withdrawals out of the plan.

In reality, one or more of those assumptions is unlikely to prove true, particularly when you’re talking about a virtual lifetime of contributions. But the point remains that a health savings account can become a long-term savings account.

You can intentionally manage it that way, but you will need to maximize your annual contributions, and then pay your medical expenses outside the plan. In that way, all funds are retained in the plan to accumulate earnings, and for later use.

While there are some definite benefits to using a health savings account as a long-term savings account, they shouldn’t be the only account you rely on for retirement. Wealthfront is a great option when it comes to retirement savings and investments. The app allows customers to invest in IRAs, 401(k)s, 529 College Savings accounts, individual accounts, joint accounts, trust accounts, and more. Investors have the option to invest in socially responsible funds and can build their own portfolio from scratch with a collection of expertly vetted ETFs.

Health savings accounts as medical IRAs

Before age 65, funds withdrawn from an HSA must be used for qualified medical expenses, or they will incur a substantial tax liability and penalty. After age 65, you can withdraw money from your HSA for non-qualified expenses without paying a penalty, but you will owe taxes on the withdrawal.

An HSA is most valuable as a way to accumulate funds to pay for future medical expenses.

It is generally assumed, and usually true, that health care expenses tend to rise in retirement. A health savings accounts can be used to cover a large part of that anticipated increase in expenses.

For example, not only can funds be withdrawn tax free to pay for qualified medical expenses, but there are significant medical expenses that fit the definition:

  • Prescription medications, including insulin
  • Amounts paid for health insurance (Medicare premiums and Medicare Supplemental Insurance premiums)
  • Amounts paid for long-term care
  • Amounts that are not covered under another health plan

Even though an HSA account cannot provide you with a source of funds for your basic living expenses before age 65, it can at least be used to cover your medical expenses in retirement. That will free up your other retirement assets, including IRAs, 401(k)s, 403(b)s, and other tax-deferred retirement savings vehicles, to pay for general expenses.

Once you hit 65, however, you can use the money in your HSA for anything you want, without paying the 20-percent tax penalty. You will, however, have to pay income taxes on any non-qualified distributions. Distributions for qualified medical expenses will remain tax free.

Exactly how much money will be in your HSA by the time you reach your retirement age will depend upon how much you put into the account, how many years you are able to fund it, what the rate of return on your investment will be, and how much you need to withdraw along the way to pay for current medical expenses.

But even with all of those considerations figured into the mix, an HSA has solid potential to become a real source of long-term savings.

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About the author

Total Articles: 179
Kevin Mercadante is a freelance personal finance blogger and the owner of his own personal finance blog, OutOfYourRut.com. A recent transplant to New England, he has backgrounds in both accounting and the mortgage industry.

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1 comment
Lauren Sekora says:

Do you have any recommendations on where to keep your HSA? Right now mine is with my employer linked custodian. I know I can shop around, but all the ones I’ve seen have high fees, low returns, and are difficult to work with.