The most underrated tax planning account?

When most people think about a Health Savings Account, or HSA, they think of it as a checking account for medical expenses. You contribute money, use it to pay a doctor's bill or prescription and move on.

But for individuals who are eligible to contribute to an HSA, treating it simply as a medical spending account may overlook one of its most valuable characteristics. An HSA can provide a rare combination of tax benefits. Contributions can be tax deductible, the money can grow tax free, and withdrawals used for qualified medical expenses can generally be tax free. There are very few accounts that offer all three benefits. For individuals who have the financial flexibility to pay current medical expenses from other assets, there is another strategy that can make the account even more powerful.

The triple tax advantage

The first benefit of an HSA is the tax deduction for contributions. Contributions made through an employer can generally be made on a pre-tax basis, while eligible individuals who make their own contributions may generally claim an above-the-line deduction, subject to the applicable rules.

The second benefit is tax-free growth. Unlike a traditional bank account, an HSA can often be invested once the account balance reaches the provider's investment threshold. The money can potentially grow over many years without generating taxable income or capital gains.

The third benefit comes when the money is withdrawn for qualified medical expenses. If the withdrawal is used for an eligible medical expense, it is generally not subject to income tax. This combination of a potential deduction going in, tax-free growth in the account and tax-free withdrawals for qualified medical expenses is what makes the HSA so unique.

Pay the medical bill today. Reimburse yourself years later.

One of the more interesting HSA strategies is to pay a qualified medical expense with money outside of the HSA rather than immediately reimbursing yourself from the account.

For example, suppose you have $5,000 in an HSA that is invested for long-term growth. You incur a $1,000 qualified medical expense. Rather than taking $1,000 from the HSA, you pay the medical bill with your checking account or credit card. You then keep documentation of the expense, including the date, amount and nature of the medical expense.

Assuming the expense otherwise qualifies under the HSA rules and was incurred after the HSA was established, you can potentially reimburse yourself from the HSA years later. There is generally no requirement that you reimburse yourself in the same year that you incur the medical expense. The IRS specifically allows HSA funds to remain in the account until they are needed, and qualified expenses incurred after the HSA was established can generally be reimbursed later.

That means the $1,000 can potentially remain invested in the HSA rather than being withdrawn immediately. If it grows over time, you may ultimately withdraw an amount equal to the original qualified medical expense without income tax, provided the applicable requirements are satisfied.

Your future Medicare premiums can be part of the strategy

The strategy becomes particularly interesting as you approach retirement. Once you reach age 65, HSA funds can generally be used tax free to pay or reimburse Medicare premiums, including premiums for Medicare Part A, Part B and Part D. One important exception is Medigap, or Medicare Supplement, premiums, which generally do not qualify for tax-free HSA treatment.

This creates an opportunity to think about an HSA as a long-term health care asset rather than simply an account for today's medical expenses. Someone who has accumulated a substantial HSA during their working years could potentially use it in retirement to pay Medicare premiums and other qualified health care expenses, while allowing the account to remain invested for as long as possible.

It is important to remember that you cannot continue making HSA contributions once you are enrolled in Medicare. However, the HSA itself remains yours, and you can continue taking tax-free distributions for qualified medical expenses after you are no longer eligible to contribute.

Think of it as creating a tax-free withdrawal reserve

This strategy effectively allows you to build a pool of documented medical expenses that can potentially be reimbursed in the future. The longer the money remains invested, the more opportunity it has to grow.

Imagine someone accumulates $20,000 of qualified medical expenses over several years but pays those expenses with other assets. They maintain detailed records of each expense rather than reimbursing themselves from the HSA. The HSA continues to grow and compound.

Years later, perhaps in retirement, that individual could reimburse themselves for some or all of those previously incurred qualified medical expenses, assuming the expenses were eligible and the necessary records have been maintained. The reimbursement would generally be tax free. They could then potentially use the HSA for future qualified medical expenses and eligible Medicare premiums.

Documentation is critical

This strategy is not simply a matter of remembering that you paid a medical bill several years ago. Good record keeping is essential.

You should retain documentation showing the expense was a qualified medical expense, the amount of the expense, the date it was incurred and that the expense was not reimbursed by insurance or another source. You also need to be able to establish that the expense was not previously reimbursed from the HSA or deducted elsewhere. The IRS specifically emphasizes the importance of maintaining records supporting tax-free HSA distributions.

For that reason, someone using this strategy should have a system for maintaining receipts and records. Digital copies can make this much easier. The goal is to create a clear record that can support the reimbursement years down the road.

The HSA can be more than a health care account

There is another reason HSAs deserve more attention in retirement planning. Once an individual reaches age 65, withdrawals from an HSA for nonmedical expenses are generally subject to ordinary income tax, similar to withdrawals from a Traditional IRA. However, qualified medical expenses can still generally be paid tax free.

That creates an interesting distinction. An HSA can provide tax-free withdrawals for qualified medical expenses while also functioning somewhat like a traditional retirement account for other withdrawals after age 65. The HSA therefore does not necessarily have to be viewed as an account that will only be used during your working years.

For someone who has sufficient cash flow to pay current medical expenses from other assets, leaving the HSA invested may allow it to become a meaningful retirement asset while preserving the ability to use it for qualified medical expenses later. And because health care costs are likely to remain a significant part of retirement spending, having a dedicated pool of assets that can be accessed tax free for eligible expenses can be particularly valuable.

The bottom line

An HSA is often treated as an account designed simply to pay today's medical bills. For some investors, that may be exactly how it should be used. But for those who have the financial flexibility to pay medical expenses from other assets, the HSA can be much more powerful.

Contributing to the account, investing the balance, paying qualified medical expenses with after-tax dollars, carefully documenting those expenses and potentially reimbursing yourself years later can allow the HSA to remain invested while preserving a future source of potentially tax-free withdrawals. Those future withdrawals could include reimbursement for previously incurred medical expenses as well as eligible Medicare premiums in retirement.

The key is to follow the rules and maintain excellent records. But when used properly, an HSA can be much more than a health care spending account. It can be a long-term tax planning and retirement planning tool that deserves far more attention than it typically receives.

Reid Schwartz is a columnist for The Item and Co-Founder of Creech Schwartz Wealth Management &Partners in Sumter, SC, where he works as a financial advisor helping individuals, families, businesses, and nonprofits plan for long-term financial success.

Tax and accountancy services are not available through or provided by Creech Schwartz Wealth Management or &Partners, LLC. This article is for educational purposes only and not to be interpreted as tax or legal advice. Any tax planning strategies discussed by Creech Schwartz Wealth Management will be in conjunction with your tax/legal professional.

Securities and investment advisory services offered through &Partners, LLC, a broker-dealer and investment adviser registered with the U.S. Securities and Exchange Commission and member FINRA, SIPC.