HSA Contributions: Spend or Invest?

Last Updated Oct 20, 2011 5:16 PM EDT

This post continues my discussion of how consumer-directed health plans (CDHP) and health savings accounts (HSAs) can improve your retirement security. You'll probably want to review my previous post to help you understand the further thoughts in this post.

In addition to covering your health expenses when you're employed, HSAs are also a great way to save money for your retirement; you're not taxed on the contributions going into your account, you're not taxed on the investment earnings, and you're not taxed on the amounts that are withdrawn from your account, as long as you use this money to pay for medical bills. You can also use HSA money to pay for Medicare premiums. These are currently at least $115.40 per month per person for Medicare Part B; add $30 per month or more if you buy a Medicare Part D prescription drug plan.

Note that the income taxes on any money contributed to a traditional IRA or 401(k) are merely deferred until you retire, whereas money contributed to HSAs truly escapes income taxes completely. Sweet!

If you withdraw contributions from your HSA for any purpose other than qualified medical expenses, however, the IRS imposes a 20 percent penalty tax. And while this tax no longer applies after age 65, the amounts withdrawn and used for non-medical expenses will be subject to income taxes.

If you let your HSA contributions remain invested, you're typically offered an array of investment options that are similar to the investment menu in your 401(k) plan. And your investment strategy for your HSA should be similar to your 401(k) investing strategy, since you have about the same time horizon. So decide the appropriate amount of exposure to stocks you're comfortable with and look for ways to minimize your investment expenses.

Should you spend the amounts in your HSA or leave them invested for the future? I prefer keeping these contributions invested for the future, provided you have enough money from other sources to pay for medical expenses you incur while you're employed. I realize with a tight economy, many people will spend the money now, but see if you can find a way to leave some money invested for the future. You won't regret it when you reach your Medicare years and have to pay for Medicare premiums and other medical expenses.

I've heard one rationale for spending your HSA money in the current year, but I don't buy it. The reason goes something like this: If you pay for medical expenses with HSA money, you're not paying income taxes on that money. If you use any other money, you're using money that's subject to income taxes, so that's less efficient. So what? The money you spend on everything else -- food, utilities, clothes, entertainment -- is paid for with after-tax money, but that doesn't stop you from paying for them, does it? And if you had money left over at the end of the year, you'd save it on an after-tax basis, wouldn't you?

For me, the real issue is whether you can afford to save more money for tomorrow through the HSA, or whether your budget is so tight that you need to spend the HSA money for medical expenses in the current year.

Can CDHP/HSA plans save money on medical bills and improve your health? Stay tuned for my next post that answers these questions.

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    For more than 35 years, consulting actuary Steve Vernon helped large employers design and manage their retirement programs. Now he's a Research Scholar for the Stanford Center on Longevity, where he helps collect, direct, and disseminate research that will improve the financial security of seniors. He also delivers retirement planning workshops and has authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.

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