Financial Tip #8: Make contributions to a health savings account a high priority

Households with high-deductible health plans (HDHPs) need to contribute to their health savings account (HSA) even if lack of funds and limited income causes them to decrease savings for other goals.

Tip #8:  The growth of high-deductible health plans (HDHPs) has increased financial risk and created an incentive for many people to reduce expenditures on essential health services.   People with high-deductible health plans need to contribute to a health savings account (HSA) to offset these risks.  When funds and income are limited, the increase saving for health care will reduce savings in retirement accounts and general liquidity.

Background on Health Savings Accounts:  

  • An HSA is a tax-preferred saving vehicle for people who enroll in an HDHP.   The primary advantage of an HDHP is reduced premiums for the employer and the insured person.   The primary disadvantage is the insured must pay a large share of health expenses.
  • The minimum deductible on a HDHP in 2022 is $1,400 for individual coverage and $2,800 for family coverage.  The maximum allowable out-of-pocket limits in 2022 are $7,050 and $14,100.   It is permissible for the HDHP deductible to be as high as the out-of-pocket limit.   A typical HDHP policy requires the insured person pay a share of all health care expenses after the deductible is met and until the out-of-pocket limit is reached.   
  • HSAs, created as part of the Medicare, Prescription Drug Improvement Act of 2003 are now a major insurance option.   An HDHP is the only plan offered by around 40 percent of employers and is sometimes the most affordable option through employers or on state exchanges.
  • People with high-deductible health insurance coverage are often exposed to large medical bills, take on high levels of medical debt, and often choose to forego necessary medical treatments. The health consequences can be especially severe for people who forego prescription drugs for chronic conditions.  
  • People can reduce the adverse health and financial impacts associate with HDHPs by contributing to an HSA. However, this study by JAMA reveals that one in three people with an HDHP do not have an HSA and that 55 percent of people with HSAs failed to contribute to their account.  An article by SHRM cites work by EBRI which found more than half of people initiating contributions to HSAs do so by reducing contributions to 401(k) plans.
  • The IRS caps the amount of funds a person can contribute to a health savings account.  In 2022 the caps on health savings account contributions are $3,650 for self-only plans and $7,300 for family plans.
  • Contributions to HSAs result in significant tax advantages.   The contribution to the account is not taxed during the year the contribution is made.   The funds are never taxed if they are used for a qualified medical expense.   Funds used for non-medical purposes prior to age 65 are subject to a 10 percent penalty.   There is no tax penalty after age 65.  
  • After age 65, funds disbursed from a HSA are fully taxed but are not subject to penalty.  Funds placed in a traditional 401(k) plan are always fully taxed but are not subject to a penalty after age 59 ½.  Fund placed in a Roth account and investment returns from funds in a Roth are completely untaxed after age 59 ½.  In addition, withdrawals of contribution to a Roth are completely untaxed at any time.

Allocation of Resources between HSAs and other saving vehicles:

People with limited income and high debt have a difficult choice between saving for health-related expenses through a health savings account or saving for other priorities.  There is no one-size fit all approach to the appropriate savings strategy.  

  • Finance Tip #2, concluded that it was okay for a person entering the workforce with high student debt to forego contributions to a 401(K) plan to prepare for emergencies, maintain a solid credit rating and rapidly reduce their student debt. An HSA reduces taxes and allows for the use of funds for medical expenses.  Young adults who have high debt and are dependent on a HDHP should likely contribute to an HSA instead of a 401(k) fund.
  • People with access to a 401(k) plan that does not match employee contributions are likely better off with a combination of a Roth IRA (see finance tip #3) and an HSA.   The HSA gives some tax relief in the year of the contribution while the Roth IRA provides substantial tax savings during retirement. 
  • Workers at a firm that matches employee contributions to a 401(k) plan should maximize receipt of the employer match, as discussed in finance tip #5 and then contribute additional funds to a mix of a Roth IRA and an HSA.
  • The choice between contributing the last dollar to a Roth or the last dollar to an HSA is affected by several factors.    
  • The HSA is the only preferential savings plan that I am aware of that allows for a tax-free contribution and distribution. HSA distributions for qualified medical expenses are never taxed.  The Roth contribution is fully taxed but all distributions after age 59 ½ are tax free and the distribution from the Roth does not increase tax incurred on Social Security benefits.  Workers nearing age 59 ½ will often prioritize Roth contributions because the tax-free distributions could be used for any purpose. 
  • HSA funds can be used to fund retirement after age 65, however, funds not used for medical expenses are fully taxed.  It makes sense to spend HSA funds for health care and retirement funds for general consumption.

Concluding Remarks:  The process of saving for retirement is complicated.  Simply plowing everything into a 401(k) is not an optimal strategy.   As noted in Financial Tip 2 people drowning in debt should even forego matching contributions into a 401(k) plan until they can bring their debt down to a manageable level.  

The growth of HDHPs complicates the savings process.  The increased likelihood of incurring high health care expenses increases the need for an emergency fund. A health savings account, like a 401(k) contribution, provides both immediate tax savings and funds for medical emergency.   The analysis presented here and in previous supports the need for investors to use diverse savings vehicles.

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