How an HSA can help cover health care costs and serve as a triple-tax-free, stealth IRA investment plan

Question: My employer has recently gone to a high-deductible health plan (HDHP), so I became eligible this year to use a health savings account (HSA). What is the best way to use my HSA?

Answer: In 2014, HDHPs must have a minimum deductible of $1,250 if you’re single ($2,500 family) and a maximum out-of-pocket amount of $6,350 ($12,700 family). The plan may offer preventive care for a lower deductible (or none at all) and still qualify. If your only health coverage is a HDHP, then you qualify for an HSA and may contribute up to $3,300 ($6,550 family), with a $1,000 “catch-up” contribution if you’re older than 55. Even if your spouse is covered by a non-HDHP, as long as you are not, you may still use an HSA, and if at least one of your children is also not covered by a non-HDHP, you may contribute the higher family amount.

There are two ways that people use their HSAs. The first is to pay for health care in the year you make the contribution. If you get a CT scan for $1,000, you use the HSA money to pay for it. Not only do you get to use untaxed dollars to pay your health-insurance premiums (at least if you’re self-employed), you also get to pay for unreimbursed health care using untaxed dollars. If you plan to use your HSA to pay your deductible and other health-related expenses in the near future, you want to invest the money very conservatively, probably in the savings-account option of your HSA.

HSAs for Long-Term Savings

The second way to use an HSA is as a “Stealth IRA.” Many physicians need to save more money for retirement each year than they are allowed to contribute to their available retirement plans. While a taxable investing account is always an option to save more, an HSA offers three significant advantages over a taxable account as a retirement savings plan. First, just like any other retirement plan, it offers an estate-planning advantage in that you can simply name a beneficiary on the account instead of having those assets go through probate. Second, although asset protection is always state-specific, your state may protect assets in an HSA from your creditors in a lawsuit or bankruptcy proceedings. Last, and most important, an HSA is the only “triple-tax-free” account.

What do I mean by triple-tax-free? Consider your 401K. You get an up-front tax deduction in the year you make the contribution. It then grows protected from the drag of taxes. Finally, when you pull out the money in retirement, you have to pay taxes on it. I consider that “double-tax-free.” A Roth IRA, into which you contribute after-tax dollars, but then is never taxed again, is also double-tax-free. But an HSA is different. You get the up-front tax deduction, just like a 401K. You get the tax-protected growth, just like a 401K and a Roth IRA. In addition, as long as the money is spent on approved health-care expenditures, it comes out of the account tax-free. Triple-tax-free. There is no minimum income required to contribute or maximum income above which you cannot contribute to an HSA.

If you find yourself wanting to save more than you can put into your retirement accounts, consider using your HSA as a Stealth IRA, the only triple-tax-free retirement account.

Advantages of HSAs

Because an HSA is the only triple-tax-free account, unless you’re receiving an employer match on your 401K, the first retirement contributions you make each year should go into your Stealth IRA. An HSA is different from a flexible spending arrangement (FSA) in that there is no “use it or lose it” provision. If you don’t spend your HSA in any given year, it just rolls over to the next year. Because you don’t need to spend this money for decades, it can be invested aggressively like any other retirement account. If you decide you don’t want to spend it on health care for whatever reason, after you turn 65, it becomes just like any other IRA. You can blow it on a boat without having to pay the 20 percent (not 10 percent like most retirement accounts) early-withdrawal penalty, although you’d still owe income tax on the withdrawal. Still, that’s double-tax-free. Most retirees, however, will have some health-care expenses in retirement because medications, Medicare premiums, and long-term-care insurance premiums are all considered eligible expenses. The 20 percent early-withdrawal penalty, as with most retirement accounts, also doesn’t apply if you die or are disabled.

There is one other loophole worth knowing about: the IRS doesn’t require you to withdraw the money from the HSA in the same year you incur the health-care expenditure. That means you can leave the money growing tax-free in the HSA and keep a running tally of your qualified health-care expenditures and receipts. Then when you need money to buy that sailboat, even before age 65, you pull it out of the account and report an equal amount of health-care expenditures from prior years on your tax form 8889 for that year. Be sure to keep your receipts in the event of an audit. The requirement is that you incurred the health-care expenditure after opening the HSA, not necessarily in the year you withdrew the money from the account—although it wouldn’t surprise me to see this loophole closed in the future.

HSAs have other advantages over employer-provided retirement accounts: you do not have to use your employer’s suggested HSA, and you can transfer HSA assets to another HSA account once per year. Employer-provided retirement and HSA accounts are notorious for poor investment choices and high costs. Even if you decide to use your employer’s designated HSA to obtain an employer-provided match, you are allowed to then transfer the money to your own preferred HSA immediately afterward, so you’re never stuck in a poor HSA for long. Recommended HSAs with low fees and solid investment options include HSA Bank, Health Savings Administrators, and Alliant Credit Union.

If you find yourself wanting to save more than you can put into your retirement accounts, consider using your HSA as a Stealth IRA, the only triple-tax-free retirement account.

James M. Dahle, MD, FACEP, blogs as The White Coat Investor at http://whitecoatinvestor.com. He is not a licensed financial adviser, accountant, or attorney and recommends you consult with your own advisers prior to acting on any information you read here.