Tax Strategy for Health Savings Accounts

Can you use a Health Savings Account to save extra for retirement? That's the suggestion from personal finance blogger "Mr. ToughMoneyLove," who urges investors to consider "Using Your Health Savings Account as a 'Super Roth' Investment Vehicle."

The blogger recommends a strategy of accumulating contributions made to an health savings account (HSA) and not making any withdrawals until retirement age. This has the benefit of letting the savings grow and the earnings accumulate and compound. In a sense, deferring withdrawals as long as possible will allow taxpayers to turbo charge their retirement savings in addition to other savings plans they might have, such as 401(k) plans and IRAs.

My colleague Shelley Elmblad, About.com's Financial Software Guide, asked me if this strategy was sound. Technically, the strategy is sound, but I do have strong reservations about the feasibility of the strategy. Here's why.

First, some basics. HSA plans are tax-exempt savings accounts paired with a high-deductible health insurance plan. Individuals can save up to $2,900 per year in an HSA; families can save up to $5,800 per year. The accompanying insurance policy has a high deductible, usually set at the same $2,900/$5,800 dollar amount. That means people will pay the first $2,900 (or whatever the deductible is for a specific policy) out of their own pocket with no reimbursement from the insurance company. The insured then has a choice to make: pay the medical expenses using funds set aside in the HSA, or pay using funds not inside the HSA.

For healthy individuals, paying out of pocket for routine preventative care might be a smart choice. Even though they are footing the bill, they avoid tapping into their HSA funds, which can then accumulate and compound tax-free until the funds are needed later. This can pay off significantly in the future when the person will need to tap significant financial resources to pay for surgery or dental work or medications.

For individuals who have significant recurring medical expenses, such as prescription medicines or regular doctor visits, this strategy doesn't work as efficiently. The individual would be paying out of pocket in exchange for tax-free growth, and at a certain point the trade off might become unsustainable. People who have recurring medical expenses are usually better off with a more traditional health insurance plan with no deductible or a low deductible. Although these policies are more expensive, they can help shield the individual from high and unexpected medical costs.

I do want to comment on two specific points made by the blogger. As part of his deferral strategy, he advises people to keep track of all their medical expenses so that they have backup documentation to show the IRS that the distributions qualify for tax-free treatment. This is a good point, but requires two further qualifications. First, only "qualified medical expenses" count as qualifying for tax-free withdrawals. "Medical care expenses must be primarily to alleviate or prevent a physical or mental defect or illness. They do not include expenses that are merely beneficial to general health, such as vitamins or a vacation," as the IRS explains in IRS Publication 502. However, qualifying medical expenses for HSA plans are slightly broader in definition than the expenses allowed in Pub. 502. The IRS explains in Publication 969, "even though non-prescription medicines (other than insulin) do not qualify for the medical and dental expenses deduction, they do qualify as expenses for HSA purposes."

The blogger's suggestion to keep track of first aid supplies such as aspirin and bandages is a good suggestion. Those are medical expenses that would be qualifying for tax-free distributions from an HSA. However, the caution here is to make sure the medical expenses do meet the criteria the IRS sets forth. Other first aid, and general health and nutrition items might not always qualify.

Also, there cannot be any double-dipping, in other words deducting medical expenses you pay for out of pocket as an itemized deduction AND then taking a distribution from an HSA in later years. Under the tax laws, you cannot take a distribution for any medical expenses you chose to deduct or was reimbursed by an insurance company. So a strategy of deduct, defer and distribute would be a no-no.

So what's the bottom line? Health savings accounts are great vehicles for accumulating tax-exempt savings while the taxpayer is healthy and doesn't have a lot of medical expenses. The basic strategy I would recommend would be to defer any distributions until the person needs to tap into them for major medical expenses. That way, the taxpayer get the double benefit of a deduct for contributions and tax-free growth. As a taxpayer gets older and requires more medical care, I'd start thinking about switching to a more traditional health policy to save on out of pocket expenses.

More about health savings accounts:

• Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans (IRS.gov)
• The ABCs of HSAs (About Health Insurance)
• The HSA Option for Small Business Health Care (About Small Business Information)
• Tax Deduction for Health Savings Accounts (About Taxes)