A Health Savings Account (HSA) is a tax-advantaged savings vehicle that lets doctors make tax-deductible contributions, enjoy tax-deferred growth, and make distributions that are tax-free when used to pay qualified medical expenses.
It’s also an excellent vehicle for physician tax planning but most doctors either don’t know about HSA’s or are using them the wrong way.
How does a Health Savings Account work?
If you are covered by a high deductible health plan (HDHP), you can contribute to a Health Savings Account. While the contribution limits change every year with inflation, in 2017 an individual can contribute up to $3,400 while a family can contribute up to $6,750. Those turning age 55 during the year can contribute an additional $1,000.
These contributions are made with after-tax dollars but they are deducted from your tax return at the time you file. That’s when you save taxes.
Inside the HSA, physicians can hold a bank deposit product (like an interest-bearing checking account) or an investment (including mutual funds). All of the dividends, interest and capital gains that happen inside the Health Savings Account are tax-free.
Unlike a 401k, contributions to a Health Savings Account generate a permanent tax deduction since no taxes are due upon withdrawal so long as the money is spent on qualified medical expenses. But this tax deduction is only the beginning.
How much tax can a physician save with a Health Savings Account?
Assuming that you are in the top federal tax bracket (39.6% + 3.8% Medicare surtax), you could save $2,929 which is $6,750 x (39.6% + 3.8%).
But the real power of a Health Savings Account lies in its ability to save taxes over the long run. Assuming a $6,750 contribution each year for 30 years and a compound growth rate of 7%, the account could be worth more than $688,000 in the future, and every penny has the ability to be withdrawn tax-free, savings hundreds of thousands in taxes that would ordinarily be paid if the money were invested outside a HSA.
Is a Health Savings Account right for me?
If you are expecting to have huge medical bills next year or if a member of your family faces chronic health issues, then a Health Savings Account is probably not right for you since it requires that you be covered by a high deductible health plan.
But if you are a physician covered by a HDHP and you are not expecting big medical bills, the HSA is probably just right for you. You just have to be comfortable with the uncertainty around getting a big unexpected medical bill and paying a big deductible.
Note that you may have no other health coverage except what is permitted by IRS Publication 969 and you may not be enrolled in Medicare.
Should I invest my HSA money?
If you are a physician and you have even a modicum of risk tolerance, the answer is yes. By investing the HSA, you let the balance grow tax-free. In much the same way that Roth IRA grows tax-free. In fact, HSAs have been dubbed “stealth IRA’s” and “Healthcare IRA’s” by some.
Shouldn’t I spend my Health Savings Account on medical bills?
Yes, of course but NOT NOW. Doctors who spend their HSA’s today will extinguish the future growth of the account which kills a huge part of the tax benefit. Instead, think of your HSA as your “retirement account for healthcare”. Given the rising cost of medical care, the fact that a Health Savings Account can be used for long term care, and the enormous costs of end-of-life care, it is highly likely that you will need every penny. For a list of qualified medical expenses you can pay with a Health Savings Account, see IRS Publication 502.
What happens if I don’t spend my HSA before I die?
If you have named your spouse as your beneficiary, your HSA becomes their HSA upon your death. Married physicians who want to keep income taxes to a minimum should designate their spouse as the beneficiary of their HSAs.
If you name someone other than your spouse as the beneficiary of your Health Savings Account, the HSA ceases to be a HSA upon your death and the full account balance becomes ordinary taxable income. Ouch!
Can I rollover my HSA into my IRA?
No, but you can roll over a portion of your Individual Retirement Account (IRA) into your HSA. This once-in-a-lifetime transfer from your IRA to your HSA is tax-free, so it effectively strips out the taxes that you would have paid on the IRA distribution. However, you can only make the transfer if you are eligible to contribute to a Health Savings Account during the year of the transfer, and the amount is limited to the same amount as a contribution. It’s hard to imagine a scenario where this loophole would benefit most physicians.
Do I have to use my employer’s HSA?
No. Unlike a 401k, you can withdraw your HSA funds or, even better, transfer them to a custodian with lower fees, higher interest or better investment options. You can do this every year if necessary. There’s nothing holding you back.
What financial mistakes do physicians make with their HSAs?
Common mistakes we see doctors make with their health Savings Accounts include:
- Choosing first dollar healthcare coverage instead of the Not opening a Health Savings Account when given the chance
- Contributing less than the maximum
- Spending the balance instead of letting it grow and paying expenses out-of-pocket
- Leaving the balance in low-yielding bank deposit products instead of investing it
- Not realizing you can put in an extra $1,000 during the year in which you turn age 55
- Forgetting that you can make a prior year contribute to a Health Savings Account right up until the tax filing deadline
What else should physicians know about managing a Health Savings Account?
If you do invest your HSA, you may be required to shift money out of the bank deposit account and into a mutual fund account or a brokerage account, often known as a “brokerage window.” Doing this may cause the cash balance to dip below a floor set by the bank, in which case you may incur fees. If these fees cause you to overdraft your bank account, the HSA provider may terminate your account EVEN THOUGH it still holds a balance in mutual funds. This is disastrous since the account can be terminated, resulting the whole account being taxed as ordinary income. Make sure to leave enough cash in the HSA to absorb whatever fees the HSA provider levies.
A HSA is not a FSA (Flexible Spending Account for Healthcare). With a FSA, it’s “use it or lose it.” With a HSA, you can keep whatever you don’t spend.
There are no income limits about HSA contributions. Anyone who qualifies may contribute, regardless of earned income.
If you use HSA money for non-medical expenses before age 65, you will be required to pay taxes on the distribution plus a 20% penalty.
What’s the bottom line on HSA’s for most physicians?
Contribute up to the limit whenever it is permissible. Invest it according to your tolerance for risk. Make sure your spouse is named as the beneficiary. Let it grow. Don’t spend it until you’re retired.
For more details about HSA’s, see IRS Publication 969 or consult your financial advisor.