ColumnistsFinancial Health

Health Savings Accounts: A Taxpayer’s Best Friend

By Jim Terwilliger

This column has often touted the benefits offered by Roth IRAs or employer-plan equivalent, Roth 401(k) plans.

Roth accounts allow you to save money for retirement tax-free if simple rules are followed. While there is no tax deduction when contributions are made, income and appreciation generated by the account’s investments are tax-free, allowing for a lifetime of tax-free distributions.

It doesn’t get any better than that! Or so it seems. But, not true.

Health savings accounts (HSAs) are unique in that they offer a tax advantage on both ends — a tax deduction at the time of contribution and a tax-free distribution when money is taken out, provided the distribution is used to pay for qualified out-of-pocket medical expenses. In between, the invested funds grow tax-free.

HSA providers offer investment options using mutual funds, much like those found in 401(k) and IRA accounts. The power of compounding allows considerable sums to accumulate over many years.

Given the likelihood of increased medical expenses in retirement, using a combination of an IRA, Roth IRA and after-tax investment accounts supplemented by an HSA may be the most prudent tax-efficient way to save for retirement. The former accounts can help fund retirement expenses while the latter can help pay for medical expenses in retirement.

In fact, contributing the maximum annually to an HSA has the potential for more beneficial tax treatment than any other type of tax-efficient account. This strategy suggests paying current medical expenses out-of-pocket during one’s working years in order to preserve and grow the HSA account balance to use later during retirement.

Qualified medical expenses are generally any expenses that would otherwise be eligible for the medical itemized deductions on your tax return. In addition to direct medical costs, they include insurance premiums for Medicare Part B and Part D, Medicare Advantage Plan (Part C) premiums, and even long-term care insurance premiums. Medicare Supplement Plan (Medigap) insurance premiums are not qualified.

Nonqualified withdrawals are those not used for qualified medical expenses. Withdrawals for medical expenses reimbursed by insurance or taken as an itemized deduction on one’s tax return are also nonqualified. Such withdrawals are taxable as ordinary income plus a 20% penalty. The penalty is waived for those who are age 65 or older, are disabled, or if withdrawn as a non-spouse beneficiary after the death of the HSA owner.

To contribute to an HSA, you must be covered under a high-deductible health plan (HDHP), not covered under any non-HDHP plan, not be enrolled in Medicare (including Medicare Part A), nor claimed as a dependent on someone else’s tax return. If these conditions are met, you may be employed, self-employed or even unemployed and still be able to contribute.

In 2021, the maximum contribution limit to an HSA is $3,600 for an individual, $7,200 for a family, plus a $1,000 “catch-up” contribution for those age 55 or older (unlike retirement accounts, where catch-up contributions apply beginning at age 50).

Funds from IRAs generally cannot be rolled over to an HSA, but there is a once-in-a-lifetime exception known as a qualified HSA funding distribution (QHFD). You can transfer funds tax-free from an IRA to an HSA up to the remaining contribution amount allowed for that year. Because the distribution is tax-free, it is not subject to the IRA 10% early distribution penalty. A QHFD can also be made from an inherited IRA and can count toward the beneficiary’s required minimum distribution (RMD).

In addition to the uniquely generous tax treatment for HSAs, there is no time limit on when funds in an HSA must be used. An HSA does not have an annual “use-it-or-lose-it” provision. As long as funds were permitted to be contributed into the HSA in the first place, funds can remain in the account for an extended period (growing on a tax-deferred basis) and be used (tax-free) later.

A tax-free distribution from an HSA can cover a current medical expense or reimburse a prior expense that was paid out of pocket. Medical expenses can occur now and be reimbursed far into the future and still be qualified, provided documentation of the medical expense is maintained, and the medical expense occurred after the HSA was originally established.

If an HSA is not used before death, a surviving spouse can continue the HSA in his/her own name and continue the preferential tax treatment. This form of HSA spousal rollover is like that permitted for retirement accounts.

With the many planning opportunities afforded by an HSA, be sure to ask your financial planner how this unique savings vehicle might fit into your retirement plan.

James Terwilliger, CFP®, is senior vice president, senior planning adviser with CNB Wealth Management, Canandaigua National Bank & Trust Company. He can be reached at 585-419-0670 ext. 50630 or by email at