Harness the power of a health savings account

Can you name a savings account that allows you to claim a tax deduction for contributions you put into it, where money in it grows tax-free and withdrawals from it are also tax-free? Yes, such an account exists: the health savings account.

In fact, an HSA is the only long-term savings accounts that allows this trifecta of tax benefits.

An HSA allows you to save and invest money that you can withdraw to reimburse yourself for out-of-pocket qualified medical expenses. The maximum annual HSA contribution in 2018 is $3,450 for individuals and $6,900 for a family. If you're at least age 55 at any time during the year, you can contribute an additional $1,000.   

To contribute to an HSA, you must be covered under a high-deductible (at least $1,350 for individuals, and $2,700 for a family plan) health insurance plan. More employers are offering HSA-eligible health insurance plans because they have significantly lower premiums due to their higher deductibles. Many employers also contribute to their employees' HSAs. In 2017, 33 percent of all HSA dollars contributed came from an employer, with the average contribution at $719.  

The tax benefits of an HSA make a powerful case for using one. Since HSAs first appeared in 2005, over 21 million Americans have established one, and HSA assets now total almost $43 billion.

But according to the latest HSA trends report by Devenir Research, most people aren't making the most of these valuable accounts. For every 10 dollars contributed in an HSA, about seven are withdrawn in the same year. Also, only about $6.8 billion of HSA assets (less than 16 percent) are held in accounts where they can be invested for growth. Instead, almost 85 percent of HSA assets are held in HSA bank accounts which pay very low interest rates. 

Why is this such a big deal? Due to much better long-term growth rates, the average HSA investment account balance is about $15,150, which is over six times more than the average HSA bank account balance.   

Here are a few strategies to help you make the most of an HSA.

Let's say you're enrolled in a high-deductible health plan, you expect to incur about $2,000 in out-of-pocket medical expenses, you don't contribute to an HSA and you're currently contributing $10,000 to your employer provided 401(k) plan. Assuming you're in a 28 percent federal tax bracket, you'll get a tax deduction worth about $2,800 (due to making pretax contributions to your 401(k)), but you've only deferred the $2,800 tax, and your permanent tax-savings from contributing nothing to an HSA is $0.

A good plan would be to reduce your 401(k) contributions to $8,000 (assumes this won't reduce any applicable employer match), contribute $2,000 to an HSA and use the money contributed to the HSA to reimburse yourself for out-of-pocket medical costs. In this example, you've deferred $2,240 in tax (due to 401(k) contributions) and permanently saved $560 in taxes due to the HSA.

A better plan would be to keep your 401(k) contributions at $10,000, contribute $2,000 to an HSA and use the money contributed to the HSA to reimburse yourself for out-of-pocket medical costs. In this example, you've deferred $2,800 in tax (due to 401(k) contributions) and permanently saved $560 in taxes due to the HSA.

The best plan is to contribute the maximum to the HSA, which is $3,450 ($6,900 for families), after first contributing the amount required to get full matching contributions under your 401(k). HSAs are so valuable that I advise people to maximize contributions to them first before increasing savings in any other type of retirement account.  

But maximizing contributions to an HSA is only part of the story. Rather than using these accounts to pay for current out-of-pocket medical expenses, you should delay taking any withdrawals from your HSA until after retirement. If you're able to do that, make sure the assets are in an investment account and allocate them into diversified stock mutual funds. This will position your HSA for a higher long-term growth rate, thus maximizing the benefit of tax-free growth.

Remember, HSA don't have a use-it-or-lose-it requirement. You can use the money now or in the future to reimburse yourself for qualified medical expenses. For many retirees, health care is likely to be one of their largest expenses. A 65-year-old couple retiring in 2017 is estimated to need approximately $275,000 to cover medical expenses throughout retirement. 

You can use your HSA in retirement for things like vision and dental care, hearing aids, nursing services and Medicare expenses, including premiums for Part B and Part D prescription-drug coverage. 

  • Ray Martin

    View all articles by Ray Martin on CBS MoneyWatch»
    Ray Martin has been a practicing financial advisor since 1986, providing financial guidance and advice to individuals. He has appeared regularly as a contributor on the CBS Early Show, CBS NewsPath, as a columnist on CBS Moneywatch.com and on NBC-TV's morning newscast TODAY. He has also appeared on the Oprah Winfrey Show and is the author of two books.