It’s a great feeling watching a bank account or investment grow.
The constantly increasing balance represents responsibility, possibilities, maybe even financial freedom.
It’s usually easy to put money into savings – but many types of bank accounts and investments have extremely restrictive rules that prevent you from taking your money back out when you want it or need it.
One of them is a health savings account.
Even though smart HSA owners use their accounts to put away tax-advantaged funds as retirement savings, health savings accounts were originally created to make tax-free funds available for the owner’s qualified medical expenses. Strict IRS rules regulating penalty-free HSA withdrawals are meant to ensure that the funds are spent on health care expenses - not cars or vacations.
But if you exercise some patience, you’ll find that obeying the rules that govern withdrawals are well worth the frustration of watching your money grow with much of it untouchable.
Here’s the lowdown on how and when you can touch your HSA funds.
Withdrawing HSA Funds for Qualified Medical Expenses
To use an HSA you have to have a high-deductible health plan, or HDHP, which can be obtained through your employer, a private insurer or the healthcare marketplace during open enrollment. Assuming you’re eligible, health savings accounts are truly a great deal when the money is used for eligible expenses.
- Every plan year you can put away thousands of dollars (plus extra “catch-up” contributions over-and-above annual maximum contributions if you’re over age 55), up to current HSA contribution limits. The funds are either contributed pre-tax (if taken via payroll deduction) or come with a full tax deduction from your gross income (if contributed directly). The contribution limits for 2019 are $3,500 for individuals and $7,000 for families. In 2020, the contribution limits increase to $3,550 for individuals and $7,100 for families.
- You don’t have to use that money; it can roll over, earning interest tax-free every year.
- But if you do choose to use it for health care costs, you can withdraw it and spend it tax-free at any time, subject to limitations that we’ll discuss in a moment.
In other words, you have a pool of tax-free money to spend on most of the healthcare expenses that your health insurance doesn’t cover. It would be hard to find anyone who wouldn’t consider that a great deal.
The most important thing to understand when using your HSA for medical expenses is knowing what is and is not allowed.
The IRS defines “qualified expenses” in Section 213(d) of the tax code and the list is long, with hundreds of entries. Their overall guideline is that expenses “must be primarily to alleviate or prevent a physical or mental defect, including dental and vision care.”
Generally speaking, you can pay doctors, hospitals, dentists, optometrists, pharmacies and medical supply providers (the latter two for prescription expenses, not most over-the-counter ones), for services provided to the account holder or a family member if they are covered under your family coverage plan. You can also withdraw money from a health savings account balance to pay for coinsurance, co-pays, and COBRA and Medicare premiums, but not regular health insurance premiums charged by your insurance plan.
Here are some other qualified medical expenses under the IRS code – and bear in mind, this is not a complete list:
- Artificial limbs and teeth
- Chiropractic services
- Contact lenses and glasses
- Diagnostic devices for medical purposes
- Fertility enhancement
- Hearing aids
- Home health care
- Long-term care, including nursing homes
- Pregnancy test kits
- Psychiatric and psychological care
- Special education
- Stop smoking programs
- Vasectomy (and reversal)
- Weight loss programs as a treatment for a medical condition
- Incidental expenses for items like transportation, parking, meals, and hotels required for medical treatment
Here are a few expenses that you CANNOT pay with your HSA funds:
- Cosmetic and other elective surgery
- Diaper service
- Funeral expenses
- Hair transplants
- Health club dues
- Maternity clothes
- Non-prescription medications
- Nutritional supplements
- Teeth-whitening treatments
- Weight loss programs not required for medical care
Important Note:he rules are different for flexible savings accounts (FSAs) and health reimbursement accounts (HRAs), so be sure that the items you are purchasing are eligible under those specific accounts.
How do you withdraw funds from your HSA account to pay for expenses?
Most HSAs provide you with a debit card, and some also supply checks, which can be used to pay doctors, pharmacies and vendors. You can also reimburse yourself the same way for expenses incurred out-of-pocket. Many HSAs also have online payment systems that let you pay bills directly from your account. Just be sure to keep detailed records for your tax return.
What happens if you withdraw money from a health savings account for a non-qualified medical expense, or for that vacation we mentioned earlier? You’ll have to pay regular income tax on the amount you take out, plus a 20 percent tax penalty. The only exception is if you’ve already turned 65; in that case, you’re only responsible for the regular taxes and not the penalty.
That brings us to the other type of withdrawal you may eventually want to make from your HSA: money to help with retirement.
Withdrawing HSA Funds for Retirement
As briefly discussed above, one of the smartest uses of a health savings account is to put away money for retirement, because of the account’s tremendous tax advantages. HSA contributions go in tax-deductible (or taken from pre-tax dollars), and the money can be left to grow in the account tax-free, rolling over every tax year without incurring any bill to the IRS.
The funds held in an HSA can be put into almost all types of investment options like mutual funds, stocks, bonds, and T-bills, so the growth in a health savings account is virtually unlimited and it’s not taxable income until it’s withdrawn.
What’s your liability when you’re ready to withdraw some of that sweet cash for retirement? Well, if the money is spent on qualified health benefits it still comes out of your HSA tax-free. Otherwise, the rules are basically the same as for non-qualified withdrawals. If you’re 65 or older you only have to pay regular income tax on the amount withdrawn. If you’re taking early retirement (and good for you!) you’ll still have to pay an extra 20 percent penalty in addition to income tax.
If you start early, make the maximum HSA contribution every year, and receive a five percent return on your invested balance each year – you could end retiring with hundreds of thousands of dollars in extra savings, which is only taxed at your normal tax rate when withdrawn in retirement (when your tax rate will likely be lower than when you were working). You’d find it difficult to find a better deal than that.
The experts at Lively specialize in easy-to-use HSAs with a wealth of investment options, to help you maximize your tax-advantaged returns. It takes only a few minutes for anyone covered by an HDHP to open a Lively health savings account online.
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.