Health savings accounts (HSAs) are projected to surpass $100 billion in assets in 2023, showing that consumers are realizing the potential power of HSAs, including as a significant wealth-building tool (there were nearly 34 million accounts in June 2022, according to research by HSA investment company Devenir). The fact that the HSA individual contribution limit is lower than that for deductible contributions to an individual retirement account (IRA) has led to HSAs often being overlooked in financial planning.
However, when best practices are used over the decades of a typical working person's career, a sizable balance can be accumulated. Pair that with health care expenses as the biggest unknown in most retirees' financial plans, and having a pot of tax-free money set aside specifically to cover those expenses can make tax and withdrawal planning in retirement much simpler.
Current law prohibits HSA contributions when any other coverage is in place, including Medicare, so getting this planning tool right is key. Waiting until the pre-retirement conversation with clients is often too late to make an impact, so CPAs and others should make a concerted effort to work with savers throughout their careers to educate them about the best uses of this tax-savings powerhouse.
Here are nine facts about HSAs that many account holders don't know but are key to making the most of this important retirement planning tool.
1. HSAs are fully portable at any time.
Much like 401(k) and 403(b) accounts, HSAs are fully portable, although assets are often left behind at prior jobs or unnecessarily spent down due to the misconception that unspent funds will revert back to the employer once the individual is no longer contributing to the account or employed with the company. In simple terms, portability means that an account holder can move their account away from the provider established by their employer.
Unlike employer-based retirement accounts, though, clients don't have to wait until they've left their company to move their HSA. In fact, HSAs can be moved to a different provider even while the account holder is still participating in the plan and contributing to the account established by the employer.
To continue making contributions via payroll deductions or to receive contributions made by an employer, clients will want to keep the employer-provided account open until it's no longer needed, but one does not need to be terminated from the employer to move their HSA. Similar to IRAs, multiple HSA accounts can be held with various providers, or accounts can be rolled over and combined.
The primary reason a client would go through the hassle of exercising this right to portability while still contributing to a different account via payroll deduction would be to move the funds to a provider that offers better investment options or to reduce fees. Each employer-provided HSA will be different, but some charge monthly maintenance fees for funds to be invested, or the funds will not accumulate interest in return for the lack of administrative fees.
For clients wishing to contribute the maximum to their account and allow funds to accumulate and grow tax-free through investing, it can be worth it to transfer funds to a more favorable provider to expand investment options, reduce fees, or even just earn interest on any portion kept in cash. This is especially true once someone has left the employer where they started their HSA.
2. Trustee-to-trustee transfer and rollover rules are similar to those for IRAs.
There is no limit on the number of trustee-to-trustee transfers that may be made, where the HSA provider performs the transfer of an account directly to a new provider. However, most providers charge a fee per transfer, so this is not a practical way to perform periodic transfers for folks who are funding their account via payroll deduction but investing it with a different provider.
In this case, account holders can perform an indirect rollover by requesting a check for the full amount of their account payable to themselves, then depositing it with the new provider within the 60-day window. However, it's incredibly important to get this one right, as the penalty for a nonqualified HSA withdrawal is 20%, plus taxation of the amount withdrawn.
Indirect transfers are limited to once per one-year period, and funds must be deposited to the new HSA within 60 days of receipt. A best practice when performing these consistently is to request the funds on a "red letter" date, such as a birthday, anniversary, holiday, etc. This way, clients won't run afoul of the one-year rule, causing unnecessary penalties and a loss of tax-free growth.
3. Account holders can make a one-time IRA-to-HSA rollover.
HSA account holders also can take a once-in-a-lifetime IRA distribution and roll it into their HSA in a tax-free transfer called a qualified HSA funding distribution. The rules here are a bit sticky, so be sure to reference the prior article "The Ins and Outs of IRA-to-HSA Rollovers," JofA, Nov. 29, 2022.
4. There is no time limit on HSA reimbursements.
This fact is the primary key to unlocking the true potential of the HSA. Because there is no reimbursement time limit, taxpayers can wait until the time of their choosing to be reimbursed from the HSA for medical expenses, even if it is years or decades later. Deferring reimbursement in this manner allows the contributions to an HSA to grow tax-free, like contributions to a Roth IRA.
Not only can funds be saved up over the years to pay for medical expenses incurred later in life, but the account can also be used for general wealth building.
For account holders who wish to use their HSA account in this manner, the best practice — sometimes called the "shoebox strategy" — is to keep ongoing records and receipts for every medical expense incurred over the years, including little things like over-the-counter medicines, menstrual products, sunscreen, and other everyday expenses that most people don't consider to be medical expenses. This expands the tax-planning feature of the HSA in retirement to include the ability to pull funds for nonmedical expenses when needed.
For example, a retiree may have a balance of $400,000 in their HSA, which is more than the estimated amount that a married couple is projected to spend on health care in retirement. However, if that person also has a record of the 30-plus years of medical expenses incurred throughout their working years, withdrawals can be made against those as reimbursements. Suddenly, that unplanned roof replacement doesn't have to lead to a taxable retirement account withdrawal that pushes the retiree into a higher tax bracket.
(Although disbursements from an HSA that are not used exclusively to pay qualified medical expenses (current or past) of the account beneficiary must be included in gross income, an otherwise applicable 20% penalty tax is not imposed on distributions on behalf of beneficiaries who are dead, disabled, or age 65 or older; see Sec. 223(f)(4)).
For more on this HSA wealth-building strategy, listen to the PFP podcast episode "Unique and Under-Communicated HSA Benefits," or read Gramlich, "How an HSA Can Be Viewed as a Flexible Tax-Favored Investment," 53-4 The Tax Adviser 26 (April 2022).
The burden of recordkeeping with HSAs falls to the account holder, though, so finding a way to save receipts over the years to justify future withdrawals in case of an IRS inquiry is important.
5. All future expenses are eligible, regardless of enrollment when incurred.
Once an HSA is established, meaning the account holder has deposited at least $1 into the account, any future expenses incurred are eligible for reimbursement from the HSA as long as the account exists. For example, if a client enrolls in an HSA-eligible plan during their healthier 20s and 30s, maximizing contributions and leaving the funds invested for long-term growth, then switches to a lower-deductible plan for their 40s when some health issues pop up, they should continue to track expenses and save receipts for future reimbursement (or they can use their HSA funds for those expenses if the alternative would be high-interest-rate debt).
It's true that they will not be able to make further contributions to the account when they are not enrolled in an eligible plan (or are enrolled in any other plan), but out-of-pocket expenses incurred can still be paid out of the HSA. Once an HSA is established and funded, it should be a habit to track medical expenses for future withdrawals up to the account balance.
6. Other coverage, including spousal FSA, negates the ability to contribute to an HSA.
A common pitfall is when an individual enrolls in an HSA-eligible insurance plan but also has other coverage. Under HSA rules, the existence of other coverage negates the ability to contribute to an HSA. This could occur, for example, when an individual who has a spouse enrolled in a flexible spending arrangement (FSA) that covers the individual and the couple's dependents enrolls in an HSA-eligible insurance plan. The IRS considers the FSA to be other coverage that disqualifies the employee from contributing to an HSA.
One way to solve this problem is to have the spouse discontinue participation in the FSA. Another possible solution, if the spouse's FSA plan allows, is to designate the FSA as a limited participation FSA (LPFSA). Payments of or reimbursements for expenses paid by an LPFSA are generally limited to qualifying dental and vision expenses. Participation in an LPFSA is not considered other coverage that disqualifies an individual from making HSA contributions.
Note that the presence of other coverage doesn't disallow enrolling in HSA-eligible insurance plans, it simply disallows contributions to the HSA. This is an important distinction in cases where the only available plan is an HSA-eligible plan through a workplace but the client has other coverage, such as Medicare Part A or TRICARE, which is available to veterans. The client may still wish to enroll in the HSA-eligible plan as first coverage; they just won't be able to fund their account for that year.
7. HSAs can be used to pay certain insurance premiums.
While HSA funds cannot be used to pay for health insurance purchased through the government marketplace, other types of insurance premiums can be paid in certain circumstances.
One is COBRA, or health care continuation coverage, as defined by the IRS. Additionally, if an individual is collecting unemployment benefits, any health care coverage premiums are also eligible, but the person then forgoes the ability to claim any tax credits or deductions for that coverage.
The IRS also allows HSA distributions to cover Medicare premiums, such as those charged by Part B and Part D (although supplemental policies are not eligible). In cases where the client's Part B premium is withheld from their Social Security benefit, the client could simply take a distribution from their HSA in the amount of their premium for the year. This doesn't increase taxable income, so it will not impact the premium itself.
Finally, up to certain limits, premiums paid for long-term-care insurance are also eligible HSA expenses, bringing some relief from the rising costs of this coverage as clients age. The amount is subject to annual limits based on age, which are adjusted annually, so be sure to check the instructions for Schedule A of Form 1040, U.S. Individual Income Tax Return (also Sec. 213(d)(10)(A), as updated for inflation in the current revenue procedure, most recently, Rev. Proc. 2022-38, §3.28).
8. HSAs are not subject to probate.
HSAs are technically considered trusts, meaning they bypass probate and pass directly to the designated beneficiary. For this reason, adding HSAs to the list of accounts to review for up-to-date beneficiaries is a good idea to ensure any remaining assets are transferred to the desired party upon the death of the account holder. However, HSAs are not a very tax-efficient way to transfer wealth, as reflected in the final fact.
9. HSAs are taxable to anyone besides a spouse who inherits them.
Naming a spouse as beneficiary of an HSA allows the surviving spouse to continue to use the account in its tax-free status for the rest of their life, but when a nonspouse beneficiary is named, an HSA is immediately payable and taxable. As such, for clients who are unmarried or widowed, making an effort to either spend down HSA assets prior to death or exhausting reimbursements of prior expenses is a good tax planning move to avoid unnecessary income taxation of the assets to the inheriting party.
For clients with a charitable intent, a best practice would be to name their desired charity as the beneficiary of any remaining HSA funds, avoiding taxation and leaving other assets to fulfill bequests.
A retirement account with a health care benefit
When used strategically, HSAs are a powerful way for clients to realize tax-free investment earnings while also providing a designated tax-free buffer against future health care costs. In cases where a client overfunds their HSA, current law allows for penalty-free distributions for non–health care expenses upon age 65, making the HSA more of a retirement account with a tax-free health care benefit.
— Kelley C. Long, CPA/PFS, CFP, is a personal financial coach in Arizona. To comment on this article or to suggest an idea for another article, contact Dave Strausfeld at David.Strausfeld@aicpa-cima.com.
