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Health savings accounts are becoming more and more popular with employers.
The main reason is the cost savings.
Health care costs continue to rise and as a result, so do the costs of health plans.
It costs the employer less to offer high deductible health insurance to employees, saving them money.
And for the right person, an HSA is a great option to pay for medical expenses.
But these accounts have both benefits and drawbacks and can be difficult to understand.
In this post, I will walk you through the 10 biggest heath savings account pros and cons so you can make the best decision for you and your family.
Table of Contents
10 Health Savings Account Pros And Cons
There are many benefits to an HSA account. I am going to cover the ones that have the biggest impact on your finances.
#1. Reduced Taxable Income
On major benefit of health savings accounts is that they reduce your taxable income, just like contributions made to your 401k plan.
Here is how this is a benefit to you.
To keep this simple, I am going to ignore all of the deductions from your paycheck except Federal income tax and your HSA contribution.
Let’s say you are paid $1,000 every two weeks and you are in the 25% tax bracket.
If you don’t contribute to your HSA, you will pay $250 in income tax and have $750 in take home pay.
If you contribute $50 to your health savings plan, you are taxed on $950 of income since the contribution is pre tax and comes out of your paycheck first.
A 25% tax on $950 comes to $237.50 and your net income is $712.50.
By making a contribution, you ended up paying $12.50 less in taxes.
Over the course of a year, you paid $325 less in tax.
As you put more money into your HSA and your income rises, your tax savings only increases.
#2. Tax Free Withdraws For Medical Expenses
What happens when you have a medical expense you need to pay?
You take the money out of your health savings account to pay for them.
When you take money out for qualified medical expenses, you do so tax free.
This means you are not taxed on the money ever.
It completely avoids Federal tax.
This is why these accounts are called a triple tax advantaged plan because you avoid all taxes.
And unlike a flexible spending account, you do not have to use the money you save in your HSA within the same year.
You can let the money accumulate until you need it.
In fact, you can let the money accumulate for decades if you want.
#3. Investments Grow Tax Free
And speaking of letting your money sit in your account, you have the option of investing your savings.
Most HSA plans feature an investing vehicle.
This means you can take some of your money and invest it into mutual funds or exchange traded funds.
And the best part is the money grows tax free.
Just like with other retirement plans, you do not pay taxes on capital gains or dividends you earn.
This is huge as your money can grow for many years without you worrying about how taxes will impact your savings.
To make this work, most people invest a portion of their HSA funds for long term expenses and keep the rest in cash as a spending account to pay for medical care today.
#4. No Penalty On Withdraws After Age 65
Let’s say you are fortunate enough to have saved a lot of money and you are now over age 65.
You can take money out of your health savings account for any reason you want, not just to pay for medical bills.
If you do use the money for non-medical bills, you will pay ordinary income tax on the money, but will not incur a penalty.
This is important to understand because most times in retirement, your taxable income is lower, meaning you will pay less tax on the money you do withdraw.
#5. No Required Minimum Distribution
I’ve mentioned that you can let your money grow for many years in your account.
This means you could decide to not spend the money until well into your retirement.
At that point, you can still use the funds to pay for medical expenses tax free.
And you are never required to take money out, unlike with a 401k plan or a Traditional IRA.
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As great as the benefits I mentioned above are, there are disadvantages to health savings accounts.
Here are the main ones you need to be aware of.
#1 Need A High Deductible Health Insurance Plan
Hands down the biggest drawback of an HSA is that you need to be covered by a high deductible plan (HDHP).
If you have an HMO or PPO coverage, you cannot use a health savings account.
The reason this is a negative is HDHP’s have much higher out of pocket expenses for you.
In a typical HMO or PPO plan, you might have a deductible of $1,000 and after you pay this amount for medical care, your health insurer starts paying.
But with a high deductible health plan, the amount you pay is much higher.
At a minimum, you are looking at $1,400 out of pocket expenses. And this number can range as high as $6,900.
This is just for individual coverage.
If you have a family, your out of pocket expenses could range from $2,800 up to $13,800 for coverage.
This is critical to understand.
Before you decide for or against a health savings account, you need to understand your health first.
If you are younger and typically do not have medical issues, you could save a lot of money with this type of insurance coverage.
This is because with few doctor visits and medical bills, the higher deductibles do not come into play.
But if you are someone with health issues, it might make sense to skip this coverage and go with an HMO or PPO as the out of pocket costs will be much less.
#2. Penalty For Non-Medical Expenses
One of the benefits I mentioned above was that when you are over age 65, you can withdraw the money from your account for non-medical purposes and not pay any penalties.
But if you are under age 65, and you do this, you will pay a penalty.
The penalty is 20% and you have to also pay ordinary income tax on the withdraw.
As a result, you are much better off finding other places to get money for non-medical expenses.
#3. Record Keeping
The issue of record keeping isn’t huge, but it is annoying.
When you use your HSA for qualified medical expenses, you need to make sure you save all your receipts.
This is because you may be asked by the IRS to prove these bills are qualified.
The key thing to understand here is you are not required to submit your receipts with your tax return.
But you need to keep them on hand in the event the IRS does ask for them.
#4. Investment Options
Investing some of the money in your health savings account for the long term is a smart financial move.
The problem however is your lack of options.
The bank that holds your money partners with a broker to offer you investment options like mutual funds and exchange traded funds.
Many times these brokers only offer a few investment options for you to choose from.
While you are not stuck with your plan provider, it is a hassle to change.
Basically you will keep your current plan provider and then have to submit a form to transfer the balance in your HSA every so often to move your money to a different plan provider.
Some plans limit the number of transfers in a year and others charge a fee, so you might have to be strategic with how often you want to make a transfer.
#5. Investment Fees
The final drawback with an HSA is that the investments offered typically have high fees.
And this fee is not limited to the investment itself.
The plan provider often charges transfer fees and account inactivity fees.
Plus you have a monthly fee if your balance is below a certain amount.
Again, you aren’t stuck with the plan your employer is offering, but making the switch isn’t as simple as it sounds.
It is highly recommended before you do anything, you decide what your goal is and then find the best provider for you.
For example, I wanted to invest in Vanguard ETFs and did a lot of research to find the plan provider that best fits my needs.
The one I use does charge an inactivity fee and a transfer fee.
So I make one transfer a year to limit the transfer fee and that one transfer is enough to avoid the inactivity fee.
At the end of the day a health savings account is a smart financial move for a good segment of people.
You can save money in your account to pay for medical bills today as well as save money for future medical expenses as well.
It is recommended you do your own research to determine if an HSA makes sense for your financial situation.
I have over 15 years experience in the financial services industry and 20 years investing in the stock market. I have both my undergrad and graduate degrees in Finance, and am FINRA Series 65 licensed and have a Certificate in Financial Planning.
Visit my About Me page to learn more about me and why I am your trusted personal finance expert.