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 95% 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 recommend keeping two to three years’ worth of routine medical expenses in cash,” says Rob Williams, vice president of financial planning at the Schwab Center for Financial Research. But any funds in excess of that could be invested for potential growth—for two reasons:
- Given the likelihood that health care costs will be even higher in the future, it may be wise to do all that you can to get ahead of them. Indeed, a 65-year-old couple retiring today can expect to need as much as $363,000 in savings to cover Medicare premiums and out-of-pocket costs.2
- If you use HSA funds for things other than health care expenses after age 65, you’ll pay only ordinary income tax with no other penalty—putting the funds on par with withdrawals from 401(k)s and IRAs, with the added advantage that HSAs aren’t subject to required minimum distributions. (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. You can contribute up to $3,550 in 2020 ($7,100 for families), plus an additional $1,000 in catch-up contributions if you’re 55 or older. 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 the 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.
2Paul Fronstin and Jack VanDerhei, “Savings Medicare Beneficiaries Need for Health Expenses in 2019: Some Couples Could Need as Much as $363,000,” ebri.org, 05/16/2019.