Health savings accounts (HSAs) are particularly prized for their triple tax advantages: Contributions are tax-deductible,1 earnings are tax-free, and withdrawals are tax-free when used for qualified medical expenses. However, roughly 94% of HSA holders keep their accounts entirely in cash, according to the Employee Benefit Research Institute. Account holders who don't invest their HSA contributions could be missing an opportunity to earn tax-free returns.
“We generally suggest keeping two to three years’ worth of routine medical expenses in cash within your HSA,” says Rob Williams, Certified Financial Planner™ (CFP®) and vice president of financial planning at the Schwab Center for Financial Research. Then, any excess funds could be invested for potential growth—for two reasons:
- Given the likelihood that health care costs will be even higher in the future, doing all that you can to get ahead of them may be wise. Indeed, a 65-year-old couple retiring today can expect to need as much as $325,000 in savings to cover Medicare premiums and out-of-pocket costs.2
- After age 65, you can use HSA funds for things other than health care. If you do so, you’ll pay only ordinary income tax on withdrawals with no other penalty—putting the funds on par with withdrawals from 401(k)s and IRAs. Add in the advantage that HSAs aren’t subject to required minimum distributions, and HSAs can be a compelling option for retirement savings overall. (Nonqualified withdrawals made prior to age 65 are subject to ordinary income tax plus a 20% early withdrawal penalty.)
To contribute to an HSA, you must participate in an eligible high-deductible health care plan—often, but not always, offered through an employer. For an individual account, you can contribute up to $3,600 in 2021 ($7,200 for families), plus an additional $1,000 in catch-up contributions if you’re 55 or older. In 2022, the annual contribution will increase to $3,650 for self-only coverage and $7,300 for families with no change to the catch-up contribution.
Once you have sufficient funds in the account—most require you to maintain a minimum cash balance—you can start to invest additional funds based on your risk tolerance, your time horizon, and, ideally, a diversified portfolio or other investment choices offered by your HSA administrator.
1While HSA contributions are exempt from federal income tax, they are not exempt from state taxes in California or New Jersey.
2Betsy Jaffe, “Savings Needed for Medicare Beneficiaries’ Health Expenses Declines,” Employee Benefit Research Institute (EBRI), 05/20/2021, https://www.ebri.org/docs/default-source/ebri-press-release/pr-1264-savingstargets-28may20.pdf?sfvrsn=5e993d2f_2.