The HSA: Three Tax Advantages, and the One Most People Waste

A health savings account is the only account in the tax code with three advantages at once: contributions are deductible, the balance grows tax-free, and withdrawals for qualified medical expenses are tax-free.

A 401(k) taxes you on the way out. A Roth taxes you on the way in. An HSA does neither, provided the money is eventually spent on healthcare — and over a lifetime, essentially everyone spends money on healthcare.

The catch is eligibility: you have to be covered by a qualifying high-deductible health plan, which is a specific definition rather than a description of how expensive your plan feels.

Four conditions, all of which have to be true on the first day of the month for that month's eligibility.

The default behaviour is to pay this year's medical bills straight from the HSA card. That captures the deduction and nothing else, because the money never stays long enough to grow.

The alternative, if your cash flow allows it, is to pay current medical costs from ordinary savings, leave the HSA invested, and keep every receipt. There is no deadline for reimbursing yourself: an expense incurred today can be reimbursed tax-free in twenty years, as long as the account existed when the expense was incurred.

That single feature is what makes the HSA a retirement account in disguise. The balance compounds untaxed for decades, and the accumulated receipts are a standing right to withdraw that amount tax-free whenever you want it.

Broader than people assume, and the definitive list is in IRS Publication 502. Deductibles, copays, prescriptions, dental and vision are the obvious ones.

Some are less obvious: certain over-the-counter medicines and menstrual products, long-term care premiums within limits, and COBRA premiums. Health insurance premiums generally are not qualified, with defined exceptions.

Getting this wrong is expensive before 65. A non-qualified withdrawal is taxed as income and carries a 20% penalty on top — double the penalty on an early retirement account withdrawal.

The account changes character. From 65 the 20% penalty on non-qualified withdrawals disappears, so money taken out for anything at all is simply taxed as income — which makes it behave like a traditional IRA.

Qualified medical withdrawals remain completely tax-free, at any age. So the account is strictly better than a traditional IRA from that point: identical treatment for general spending, better treatment for healthcare.

Two details worth planning around. Enrolling in Medicare ends contributions, and it can do so retroactively for up to six months, so stopping contributions ahead of enrolment matters. And an HSA inherited by anyone other than a spouse generally loses its tax status entirely — the beneficiary designation is worth getting right.