Pros and Cons of HSAs

Health savings accounts (HSAs) provide several tax advantages to people saving for future medical expenses. They also move with you if you change jobs, and unused funds roll over at the end of the year. However, to be eligible for an HSA, you must participate in a high deductible health plan (HDHP), which exposes you to potentially high medical bills. Another drawback is that HSAs can only be used for qualifying medical expenses, and violating that rule can mean steep penalties.

A financial advisor could help you put together a financial plan for your healthcare needs and goals in retirement.

HSA Basics

A health savings account is a tax-advantaged savings account designed to help individuals pay for qualified medical expenses. HSAs are available only to people enrolled in an eligible high-deductible health plan. Account holders can use HSA funds to pay for a wide range of healthcare costs, including deductibles, copayments, prescriptions and other qualified expenses.

Individuals, employers or both can contribute to an HSA, subject to annual IRS contribution limits. The funds belong to the account owner and remain in the account from year to year, even if the individual changes jobs or health plans. Unlike flexible spending accounts (FSAs), HSAs generally do not require participants to spend their balances by the end of the plan year.

HSAs offer a unique triple tax advantage. Contributions are generally tax-deductible or made with pre-tax payroll deductions, investment earnings grow tax-deferred and withdrawals are tax-free when used for qualified medical expenses. Because of these tax benefits, some people use HSAs not only for current healthcare costs but also as a long-term savings vehicle for medical expenses in retirement.

Many HSA providers allow account holders to invest a portion of their balance once a minimum cash threshold is met. Depending on the provider, investment options may include mutual funds, exchange-traded funds (ETFs) and other securities. Investing HSA assets can provide additional growth potential, although investment returns are subject to market risk.

HSA Pros

Tax advantages represent the biggest draw of HSAs. Contributions by employees, employers and family members do not count as currently taxable income for federal income tax purposes. That includes FICA taxes as well as federal income taxes. This gives HSA savers immediate tax savings. Further, taxpayers can claim HSA contributions as deductions even if they don’t itemize on their returns.

Tax-free growth means that interest and other gains on the funds in an HSA are also free of federal income taxes. Additionally, tax-free withdrawals allow savers to take out the money to pay qualified medical expenses without, again, incurring any federal income tax.

Another pro of HSAs is that they belong to the employee and can be kept through any number of job changes. The balance is not forfeited if it isn’t used in any given year and instead continues to increase through paycheck deductions and investments gains.

Also, HSAs aren’t subject to required minimum distributions (RMDs). That means retirees don’t have to take funds out of their HSAs unless they have qualified medical expenses they want to use the funds for.

HSA Cons

A woman and her healthcare provider discussing the pros and cons of HSAs.

A big drawback of an HSA is that you have to sign up for a high deductible health plan to be eligible for one. It is difficult to forecast medical expenses accurately. So a family hit with a surprise medical expenses could have to spend as much as $16,600 in out-of-pocket costs in a single year before insurance starts paying costs.

Further, tax-free HSA withdrawals are only permitted for qualified medical expenses. That can cover expenses like doctor bills, prescription medications and lab tests as well as insurance copays and co-insurance. However, it doesn’t include other health-related costs, such as gym memberships and cosmetic surgery.

If withdrawals are used to pay for non-qualified expenses, the IRS will levy a 20% penalty on the amount withdrawn. In addition, the withdrawals will be taxed as ordinary income. HSA users may have to keep detailed records showing that withdrawals were used for qualified expenses, or risk these penalties.

Other considerations include the fees that HSAs charge. These can add up over time, though they are generally much less in comparison to the potential tax savings that HSAs offer.

Another limitation of HSAs is that people who are covered by Medicare, which includes most people over age 65—cannot make contributions to their HSAs. However, they can keep their HSA and use the funds to pay future medical costs.

Finally, some states do not exempt HSA contributions from state income taxes. So while an HSA can save on federal income taxes, it may not help with state taxes.

Using an HSA for Your Retirement

An HSA can serve as a valuable part of your retirement strategy. Because contributions are tax-deductible and growth as well as qualified withdrawals are tax-free, HSAs are sometimes called “triple tax-advantaged” accounts. This makes them an efficient way to save for the high cost of healthcare in retirement.

One way to use an HSA for retirement is to help cover Medicare expenses. Once you turn 65, you can use HSA funds to pay for Medicare Part B and Part D premiums, as well as out-of-pocket costs such as deductibles and copayments. Long-term care insurance premiums also qualify, up to certain limits set by the IRS. These are expenses most retirees face, and using tax-free HSA dollars to cover them can ease the burden on your other retirement accounts.

After age 65, you can also use HSA withdrawals for non-medical expenses without facing the 20% penalty that applies to younger account holders. While these withdrawals are still taxed as ordinary income, this effectively makes the HSA function like a traditional IRA once you reach retirement age. This flexibility allows you to use the account both as a dedicated healthcare fund and as a supplemental retirement account if your medical expenses are lower than expected.

Another advantage of HSAs in retirement is that they are not subject to RMDs. Unlike traditional IRAs or 401(k) plans, you are not forced to withdraw funds at a certain age. This gives you more control over when and how you spend the money, allowing the balance to continue growing tax-free for as long as you choose to keep it invested. For retirees who do not need to tap their HSA immediately, this can be an effective way to preserve assets.

Finally, building an HSA balance early in your career can create a significant resource for later years, when healthcare costs tend to rise. Many retirees face expenses for prescriptions, hospital stays, dental care, vision care and long-term care. By treating your HSA as both a medical savings account and a long-term retirement tool, you can prepare for these costs while enjoying tax advantages along the way.

When It Makes Sense to Open an HSA

Opening an HSA makes the most sense if you’re enrolled in a qualifying high-deductible health plan. Because HSA eligibility is tied to this type of coverage, it’s important to confirm that your health plan meets IRS requirements before opening an account. If you qualify, an HSA can provide tax advantages while helping you prepare for current and future medical expenses.

An HSA may be especially valuable if you can contribute regularly without needing to spend the funds immediately. Leaving money in the account allows it to grow tax-deferred, and any investment earnings can compound over time. For individuals who can pay current healthcare expenses out of pocket, an HSA can serve as an additional long-term savings vehicle.

Healthcare expenses often increase with age, making an HSA a useful supplement to traditional retirement accounts. Funds can be used tax-free for qualified medical expenses in retirement, and after age 65, withdrawals for non-medical purposes are allowed without penalty, although they are generally subject to ordinary income tax. This flexibility can make an HSA a valuable component of a broader retirement strategy.

An HSA can be a good option for individuals looking to maximize tax-advantaged savings. The combination of tax-deductible contributions, tax-deferred investment growth and tax-free withdrawals for qualified medical expenses is unique among savings accounts. For those who expect ongoing healthcare costs or want another tax-efficient way to save, an HSA may offer meaningful long-term value.

Bottom Line

There are several pros and cons of HSAs.

Health savings accounts can offer significant tax advantages while helping you prepare for both current and future healthcare expenses. However, HSAs are only available with eligible high-deductible health plans, and those plans may require you to pay more out of pocket before insurance coverage kicks in. Weighing the tax benefits, investment potential, healthcare needs and costs of an HDHP can help you decide whether an HSA makes sense for your financial plan.

Tips on Paying for Healthcare

A financial advisor can help you put a financial plan into action for your healthcare needs. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
HSAs are generally seen as most attractive for younger, healthier people who don’t spend a lot on healthcare. Older people and those with chronic conditions that result in large health costs may be better off with traditional insurance that has no HSA but a lower deductible.