What Is an HSA and How Does It Work?

A health savings account (HSA) is a tax-advantaged investment account that can be contributed to by individuals with a high-deductible health insurance plan. Employers often offer HSAs as a benefit, but individuals can also open their own accounts. Contributions are tax-deductible up to the annual HSA limit, and funds can be withdrawn tax-free to pay for qualified medical expenses.

HSAs offer unique benefits, including eligibility for contributions only with a qualifying high-deductible health plan, the option for employers to open and contribute to the account or individuals to do so themselves, and the ability to invest funds and allow them to grow indefinitely without required minimum distributions. Unlike other tax-advantaged accounts, such as 401(k)s and traditional IRAs, funds from an HSA can be withdrawn tax-free at any age to pay for qualified medical expenses. Withdrawals for non-qualified expenses before age 65 are subject to a 20% penalty plus income taxes, but after age 65, funds can be withdrawn for any purpose without penalty, although ordinary income tax will be due if the funds are not used for healthcare expenses.

How does an HSA work?

Health savings accounts (HSAs) can function as an important savings vehicle, making it easier to afford medical care and helping you save for retirement. However, there are eligibility restrictions and annual contribution limits that must be followed.

The rules governing HSAs are distinct from those for flexible spending accounts (FSAs), despite both allowing you to pay for medical care with pre-tax funds.

Investing in an HSA

One of the most significant benefits of HSAs is that they can be more than just a savings account for healthcare expenses. This is because you are generally permitted to invest the money in the account, which need not remain in cash. This provides an opportunity to:

• Invest pre-tax money in the market
• Increase your wealth through investments without paying taxes on your gains
• Withdraw your money tax-free for medical purposes, including any gains you’ve made

No other investment account allows pre-tax money to be put into the stock market, earn a return on investment, and never pay taxes on any money made through investing. Since the IRS doesn’t take a cut, an HSA can be a wealth-building powerhouse of an account, and all returns on investments earned belong to the account holder.

Of course, if you use the money for non-medical purposes, you’ll be taxed on withdrawals at your ordinary income tax rate. You’ll also owe a 20% penalty if you’re younger than 65. Nevertheless, even if this approach is taken, you have the chance to invest with pre-tax dollars and defer taxes on gains with this account, similar to a 401(k).

Your investment options depend on where you hold your HSA account, but you’ll often have a selection of index funds comparable to those offered by a 401(k). These funds can allow you to gain broad exposure to the entire stock market or specific types of companies, such as large, mid-sized, or small companies. You may also have access to bond funds, real estate funds, or emerging market funds.

Investing in funds is typically straightforward even for novice investors, and the risks are lower than when investing in individual stocks. This makes using your HSA as an investment vehicle an easy and tax-efficient way to start investing in the stock market.

However, if you plan to use the money in an HSA within two to five years of contributing it, it’s generally advisable to leave it in cash or a cash equivalent to avoid being subject to stock market volatility.

If you intend to leave your money to grow to cover healthcare costs later in life or as an additional retirement account, you should strongly consider investing the money so you can earn returns.

Opening and Funding an HSA

Individuals with a qualifying high-deductible health plan may have access to an HSA through their employer. If this option is available, it may be a desirable choice, particularly if the employer contributes to the HSA. Alternatively, several reputable financial institutions offer HSAs, such as Lively and HSA Bank. Lively provides an FDIC-insured savings account option and the ability to invest in virtually any stocks, bonds, ETFs, or mutual funds through TD Ameritrade’s platform. HSA Bank offers HSAs with the option to invest through TD Ameritrade’s platform or a guided self-directed investment program that helps invest in low-fee mutual funds. Note that although individuals can have multiple HSAs, contribution limits apply in aggregate. Therefore, it is important to keep track of the total amount invested across all accounts and file a separate Form 8889 for each HSA. For simplicity, it is advisable to stick to maintaining one HSA.

When choosing between an employer-provided HSA and an HSA offered by a financial institution, consider which option aligns best with your goals. If an employer contributes to a specific HSA, that is typically the best choice. If not, it is a good idea to compare features of the employer’s plan (if any) with those of other options. For example, individuals interested in buying individual stocks within their HSA will need to identify an institution that allows this.

HSAs allow individuals to set aside pre-tax dollars to pay for medical care. Because these funds can be invested or held in cash, HSAs offer more than just a means of saving on medical costs. Utilizing an HSA as a long-term investment vehicle could reduce healthcare expenses in retirement and lower tax bills over time.