Tax Advantages of a Health Savings Account, Part 2

2. Tax-Deferred Growth

The money in the HSA rolls over each year and grows tax-free. Unused funds roll over year to year; there is no “use it or lose it” penalty.

Depending on the HSA provider, you may invest the HSA money in money market accounts, bank certificates of deposit, stocks, bonds, mutual funds, Treasury bills, and notes. You can even obtain a self-directed HSA that gives you complete control over how your money is invested.

You may take distributions from your HSA at any time. But, unlike with a traditional IRA or 401(k), you don’t have to take annual required minimum distributions from the account after you turn age 73.

When you die, if your spouse is the designated beneficiary of your HSA, it will be treated as your spouse’s HSA. There is no tax to be paid.

If you have an HSA beneficiary other than your spouse, the account stops being an HSA when you die, and its fair market value becomes taxable to the beneficiary.

3. Tax-Free Distributions for Medical Expenses

You pay no tax on distributions you make from your HSA to pay for qualified medical expenses for yourself, your spouse, or your dependents.

No other tax-advantaged account gives you both a tax deduction for contributions and tax-free distributions. Let’s compare to the following:

• With IRAs, you get one or the other, but not Regular IRA contributions are deductible, but distributions are taxed.
• With Roth IRAs, distributions are tax-free after five years, but you get no deduction for

Qualified medical expenses are broadly defined to include any medical or dental expense that qualifies for the itemized deduction for medical expenses. It also includes insurance premiums for long-term care, COBRA health care continuation coverage, and Medicare if you are 65 or older.

If you take distributions to pay for anything other than qualified medical expenses, you must pay income tax on the amount at ordinary income rates. If you’re under age 65, you must also pay an additional 20 percent penalty tax on the distributions.

Did You know? There is no time limit on when you may take a distribution to pay for qualified medical expenses. For example, you can take a tax-free distribution in 2025 to reimburse yourself for a medical expense incurred in any earlier year, as long as the expense was incurred after you established your HSA.

What are the Best Uses of an HSA?

The best way to use an HSA is to take full advantage of its three tax benefits. This means you:

1. contribute the maximum amount every year until you enroll in Medicare
2. defer taking distributions as long as possible
3. take tax-free distributions only to pay for medical expenses

Do your best to max out your HSA contribution each year before you put any money into retirement accounts such as IRAs or 401(k)s. Because of the HSA’s three tax benefits, money invested in an HSA can be worth far more than a like amount invested in any other account.

If you max out your HSA each year and don’t take many distributions, you could end up with a substantial sum saved. A family that makes maximum HSA contributions for 30 years can end up with nearly $1 million after 30 years, based on an annual seven percent growth rate. A couple that opens an HSA at age 50 could have over $200,000 in their account by the time they reach age 65 and enroll in Medicare. Personal finance experts estimate that an average retired couple aged 65 will need at least $300,000 to cover health care expenses in retirement. Some will need more.

Don’t Miss Out on These Tax Benefits:

No other tax-advantaged account gives you these three benefits:

• a tax deduction for contributions
• tax-free growth
• tax-free distributions

As always, review your own needs and talk with a professional to make an informed decision. The money you save today is the money that will save you tomorrow.

Esther Phahla is a Certified Public Accountant (CPA) and Certified Tax Strategist (CTS) in Temecula. She also holds a Master’s of Science in Taxation. She is the Author of Tax Planning books: “Why Didn’t My CPA Tell Me That” and “10 Most Expensive Tax Mistakes That Cost Business Owners Thousands. ” Esther is passionate about proactive tax planning being the key to reducing taxes. She spends hundreds of hours taking continuing education classes to ensure that she provides the best solutions for her clients. Over the years, Esther has helped hundreds of business owners save thousands in tax. She has given seminars on proactive tax planning as well as written a number of articles on the topic. She can be reached at (951) 514-2652 or visit www.estherphahlacpa.com.