HSA: The Best Retirement Account

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Imagine if there was a way to avoid paying income taxes. You would earn money tax-free, invest it in a tax-free account and withdraw it tax-free. Wouldn’t that be amazing? What if I told you that this is actually possible today, at least for some part of your income? Indeed, you can utilize the triple tax advantage of the Health Savings Account (HSA) to achieve this. That is why HSA is the best retirement account.

In my previous post titled “8 Critical Decisions for a Successful Investing Strategy” I explained the investment order, i.e. how to prioritize which accounts to invest in. The HSA is quite high in the list. The goal of this post is to explain how to take full advantage of your HSA account. I will start with the basics about the HSA and build as we go along. However, if you are quite familiar with the HSA, you can skip directly to the section “Summary: How to optimize your HSA for retirement“.

What is a Health Savings Account (HSA)?

From a high-level perspective, an HSA is a personal savings account that you can use to pay for health expenses. Conceptually, it is very similar to a savings account that you open in a bank:

• Debit card: the HSA provider gives you a debit card that you can use to pay for eligible expenses.
• Contributions: You can add money to the HSA account either directly from your paycheck (pre-tax contribution) or by transferring it from your bank (however this option is not very tax-efficient as we’ll explain below).
• Investments: You can transfer this money into an investment account for investment purposes, e.g. to purchase stocks, bonds, index funds, etc
• Interest: The money in your HSA account gives you interest, similar to the interest from a checkings account
• Online access: You can access the account online, e.g. to view your balance, check transactions, etc

The main limitation of an HSA account compared to a savings account is that you can only use it to pay for health expenses. If you use the money to pay for non-medical expenses, then you pay a 20% tax penalty for these funds (on top of your tax contributions).

Benefits of an HSA

In the previous section we discussed about the similarities between a savings account and an HSA. However, an HSA provides many more benefits:

1. Tax-free payments for medical expenses:
   • The main purpose of an HSA account is to pay for medical expenses with pre-tax money.
     • For example, if your marginal tax bracket is 32%, then you can either buy $100 of medical using $100 from your HSA (pre-tax) or $100 from your savings (post-tax). In the second scenario, your payment corresponds to $147 of pre-tax income, so you’d be losing almost 50% compared to an HSA payment
   • If you pay for non-medical expenses from your HSA and you are younger than 65 years old, then you’d pay a tax penalty of 20%
2. Triple Tax advantage:
   • Tax-deductible contributions:
     • If you contribute to an HSA directly from your paycheck (pre-tax contribution), then you don’t pay any taxes.
     • If you contribute from a bank account (post-tax contribution), then you pay limited taxes. We will discuss this in more detail below
   • Tax-free investment: The earnings from your contributions are not taxed
   • Tax-free withdrawals: You don’t pay taxes when you withdraw funds from the HSA
   • Exception: The states of California (CA) and New Jersey (NJ) do not recognize the tax advantages of the HSA.
     • If you live in CA or NJ, you will still pay state taxes for contributions and earnings, but you will not pay Federal taxes
3. Earnings potential:
   • Interest-bearing account: You have the option to leave your contributions (either the full balance or some part of it) as cash and earn tax-free interest
   • Investment capabilities: You can have the option to invest your contributions (either the full balance or some part of it) in a set of investment options (e.g. stocks, bonds, index funds) that are provided by your HSA provider. These earnings will be tax-free
4. Employer contributions:
   • Most employers contribute some amount (e.g. $500 or $1,000) to the employee’s HSA every year
   • This amount is tax-free and in addition to the employee’s compensation (i.e. it’s “free money”)
5. Flexibility:
   • You own the account:
     • Similar to a 401k or an IRA, the amount of money that is added to the HSA is owned by you and not by your employer.
     • Unlike an FSA (Flexible Spending Account), you don’t lose the money when the calendar year ends or if you change employers
   • When you become 65 years old, the HSA becomes a Roth IRA account:
     • You will no longer need to use it only for medical expenses. Instead, you’ll be able to withdraw that amount tax-free anytime
     • Unlike a 401k, you won’t need to do RMD (Required Minimum Distributions)

If you are interested in diving deeper into the advantages of the HSA, you can also look at the IRS website for HSAs.

Who is eligible for an HSA?

In order to be eligible for an HSA account you:

• Must be enrolled in a qualifying High-Deductible Health Plan (HDHP)
  • HDHP definition: The IRS has specified for that 2020, the HDHPs need to have a minimum annual deductible of $1,400 for individuals and $2,800 for families. The maximum annual out-pocket expenses are set to $6,900 for an individual and $13,800 for a family
  • Last-month rule: If you were enrolled on an HDHP on the first day of the last month of the tax year (i.e. December 1st), then you are considered to be eligible for the HSA for the whole year
• Can’t have any other supplemental health insurance coverage
  • You can’t be covered by your spouse’s health insurance, your parent’s health insurance or any other health insurance in the US or abroad
• Can’t be claimed as a dependent on someone else’s tax return
• Can’t be enrolled in Medicare (Part A and Part B) or Medicaid
• Must be under the age of 65

How to optimize your HSA contributions

1. Contribution sources: payroll vs post-tax
   • If you contribute to the HSA directly from your payroll, then your contribution is 100% tax-free (which the exception of the residents of CA and NJ, who will have to pay state taxes)
   • If you contribute to the HSA from your savings (post-tax), then you need to pay Social Security (6.2%) and Medicare (1.45% or 2.35%)
   • As a result, it’s more preferable to contribute to your HSA directly from your payroll
2. Contribution limits (set by the IRS):
   1. For 2020
      • If you are covered by an individual health plan: $3,550
      • If you are covered by a family health plan: $7,100
      • For people age 55 or older: additional $1,000 (on top of the above limits)
   2. For 2021
      • If you are covered by an individual health plan: $3,600
      • If you are covered by a family health plan: $7,200
      • For people age 55 or older: additional $1,000 (on top of the above limits)
3. Excess contributions: If you contribute more the maximum limits for a specific year, then you have 2 options:
   1. Withdraw the amount before the tax deadline of the next year (i.e. before April 15th of next year) OR
   2. Leave the money in HSA and pay an additional tax equal to 6% of your excess contribution.
      • You will keep paying this tax for every year that the excess contribution remains in your HSA.
      • You can stop paying it, if you contribute less to your HSA the next year (i.e. your next year’s HSA max contribution is reduced by an amount that is equal to your excess contribution)
4. Contribution deadline:
   • You can make contributions to the HSA for a specific year from January 1st until April 15th of next year.
   • For example, your 2020 contributions can be made anytime between 1/1/2020 and 4/15/2021

How to pay for medical expenses using your HSA

As I mentioned above, the HSA is typically used to cover medical expenses. So, if you have a medical expense, there are 3 strategies that you can use, in order to pay it.

Strategy #1 (worst option): Pay directly from the HSA

This strategy is the simplest and most common one. Anytime that you have a medical expense, you can use the HSA debit card to pay for it. The advantage of this option is the simplicity. However, the disadvantage is that you are using money that could grow tax free for years.

Strategy #2 (better option): Pay using a credit card that provides rewards and immediately reimburse from HSA

This is a slightly better alternative to strategy #1. If you use a credit card that provides rewards, then you gain e.g. 3%-5% of your expense immediately. Then you can directly withdraw money from your HSA account, in order to pay you back. The withdrawal will be tax-free.

The disadvantage of this approach is that you need to spend a little more time than option #1, since you have to do a few more steps, in order to pay yourself back. However, you are awarded by gaining 3%-5% of your expenses.

Strategy #3 (best option): Pay using a credit card that provides rewards and reimburse yourself in the far future

The last strategy is the best one for the long-term investor, who is interested in reaching FIRE (Financial Independence Retire Early). The difference between this strategy and option #2 is that you don’t pay yourself back at the same year that you incur the expense. Instead, you keep the receipts in a digital format (e.g. scan them and upload them to cloud).

You invest your HSA money in a low-fee index fund that is provided by your HSA provider. The money grows and your earnings multiply. You can withdraw the expense anytime, so why do it immediately? You can wait until retirement and then decide the best time to withdraw this amount.

Important: Set your spouse as the designated beneficiary for your account

In the even of your death, the HSA balance is transferred to a beneficiary. If you have set your spouse as the designated beneficiary, then your HSA balance is transferred to your living spouse’s HSA tax-free. If your spouse is not the designated beneficiary, then the amount becomes taxable to your beneficiary in the year that you die.

What medical expenses are eligible for HSA reimbursement?

You can find a detailed list of all eligible HSA expenses in the “What’s Eligible?” list by Lively. The list includes (but is not limited to):

• Deductibles
• Copays
• Coinsurance
• Out-of-pocket costs related to diagnostic services like x-rays and blood tests
• Prescriptions
• Quality of life enhancers like air purifiers (with a letter of medical need)
• Medical supplies like band-aids and crutches
• Alternative medicine treatments like acupuncture

Changing HSA providers

Most people open an HSA, when they enroll into an High Deductible Health Plan (HDHP) as part of their medical coverage by their employer. The employer pre-selects an HSA provider and all the HSA funds are deposited there (both as part of the employee’s paycheck and as part of the employer’s contributions).

However, what most people are unaware of is that they have the option to move their funds to a different HSA provider. Indeed, they are the owners of the HSA funds and not their employer. This is a different model than the 401k, where it’s not possible to move the funds to a different provider without changing jobs.

Why would somebody move their HSA funds to a different provider?

There are a few reasons about why somebody might want to change HSA providers:

1. Account fees: The HSA provider might be charging annual fees
2. Transaction fees: There might be additional costs to buy/sell specific securities
3. Limited fund options: Users might only be able to only buy a small set of funds that have been pre-selected by the HSA provider. These funds might have high fees or they might not be compatible with the user’s investment strategy
4. Investment threshold: Most HSA providers don’t allow you to invest the full amount in your account. Instead, some specific portion (sometimes up to $1,000 or $2,000) has to be left in cash. This limitation decreases investment returns for the account

How to select which HSA provider to move the funds to?

If you decide to move your HSA funds to a different provider, then you should pick one that offers the following:

1. Account fees: $0
2. Transaction fees: $0
3. Investment threshold: $0
4. Minimum amount balance: $0
5. Investment options: full brokerage account

There are multiple web pages that compare the top 10-11 HSA providers, e.g. The HSA Report Card, Investor’s Business Daily, Investor Junkie, and Morningstar. I think that report from The HSA Report Card provides the best summarized view of the ranking for all providers across multiple criteria:

Based on most reports, the top 2 HSA providers are Lively and Fidelity.

Comparing the top 2 HSAs: Lively vs Fidelity

The following matrix shows a high-level overview between the top 2 HSA providers: Lively and Fidelity:

	Lively	Fidelity
Account fees	$0	$0
Investment threshold	$0	$0
Minimum account balance	$0	$0
Full brokerage choices	Yes (via TD Ameritrade)	Yes (regular Fidelity account)
Transaction fees for stocks and ETFs	$0	$0
Transaction fees for mutual funds	$25 for no-load funds (one-time), $0 for others	$0
Cash interest rate	0.01%	0.01%
Fractional ETF/stock trading	Yes, only for dividend reinvesting	Yes

In summary, both providers offer excellent choices. Choosing one or the other is more about a personal preference. The only substantial difference is whether you prefer to handle your transactions via the Fidelity website or the TD Ameritrade website.

How to transfer your HSA funds

If you decide that you want to transfer your HSA funds from your current provider to Lively, Fidelity or any other provider, then this is the best process to follow:

1. Frontload your HSA contributions, in order to reach the HSA maximum early within the year (ideally within January), in order to:
   • minimize the number of transactions between the HSA
   • maximize the amount of time that the money is invested in the market
2. Convert all investments into cash:
   • Most HSA providers do not allow “in-kind” transfer, but only allow cash transfers. Check with your HSA providers to be sure
   • Unfortunately, this is a taxable event in CA and NJ
3. Start the rollover process to transfer the assets. This form is provided by your destination provider, i.e. the one that you’ll transfer the funds to
   • Transfer assets to Lively
   • Transfer assets to Fidelity
4. Leave a minimum balance as cash in your previous provider (e.g. $25), if you want to keep your account open (e.g. for future contributions by your employer)

HSA vs FSA

Before wrapping up this post on the HSA, I wanted to provide a quick comparison between the HSA (Health Savings Account) and the FSA (Flexible Spending Account). In summary, the HSA is better in all possible areas:

	HSA	FSA
Maximum annual contributions (2021)	Individual plan: $3,550 Family plan: $7,100	$2,750
Money rolls over at year end	Yes	No
You keep the money, when you change employers or if you lose your job	Yes	No
You can rollover the money into other providers	Yes	No
You can invest the money	Yes	No

Summary: How to optimize your HSA for retirement

The following list is a summary on what you need to do, in order to optimize your HSA for retirement:

1. HSA provider: Decide if you want to stay in the HSA account from your employer or move to a zero-fee HSA provider (Lively or Fidelity)
2. Contributions:
   1. Frontload your contributions to hit the maximum annual limit as early as possible in the year
   2. Setup direct deposit from your payroll (not from your after-tax savings account), in order to maximize tax benefits
3. Investments: Invest the full amount of your HSA in low-fee index funds
4. Medical expenses: Pay them using a credit card that provides some type of rewards (cash or travel). Keep the receipts in a digital format
5. Withdrawals:
   • Try not to use the HSA for any expense. Let the money fully invested
   • If you need the money at any point in the future, you can withdraw tax free the same amount as what you have in your saved receipts
   • After 65, the HSA becomes the same as a Roth IRA, so you’ll be able to withdraw money tax-free anytime
6. Set your spouse as the designated beneficiary:
   • In the event of your death, your HSA balance is transferred to your living spouse’s HSA tax-free
   • If your spouse is not the designated beneficiary, then the amount becomes taxable to your beneficiary in the year that you die