Category Archives: HSA Benefits

The HSA – an Unemployment Safety Net

What if you lost your job tomorrow?  Just the thought of unemployment makes most people cringe.  Besides wrecking havoc on your finances, unemployment causes emotional stress and discomfort.  For the vast majority, their employer is their single biggest source of income.

Dealing with a job loss is easier if you have prepared.  As you will see, there are ways an HSA can help you during an unemployment spell.  Hopefully you are in the planning stages now and can take action.  If you are eligible but haven’t opened an HSA yet, it might be a good time to take 5 minutes to do so.

HSA contributions can benefit you in the following ways during unemployment:

Pay for Health Insurance Premiums
If you are receiving state or federal unemployment aid, you can use your HSA to pay for your health care premiums.  Yes, you read that correctly: while unemployed your health insurance premium is considered a qualified medical expense.  As you probably know, this is not the case when you are employed.

A good strategy is to build your HSA so that the account could cover 6 months of health insurance after a job loss.  There are a number of benefits to this.  For one, you continue coverage that limits your total financial liability– an important part of protecting your assets.  Moreover, you will not need to write a check for health insurance each month; you simply use your HSA funds.  This definitely helps with cash flow as money will be tight.

Thirdly, it is great piece of mind to know that no matter what happens, you can cover X months worth of health care premiums with your HSA.  You have a plan and have cash reserves to get through the worst of it.  Once your situation brightens, you can rebuild your HSA fund.

Tax Free Cash Withdrawal
Your HSA can also function as a backup emergency fund, allowing you to withdraw tax-free cash in times of need.  You can only do this by reimbursing yourself for previous Qualified Medical Expense (QME) paid out of pocket.  I call this strategy using your HSA as an ATM. The way it works is this: if you incur a QME and elect to pay it out of pocket (i.e. not with your HSA), you can reimburse yourself for it from your HSA at any time in the future.  This simply involves transferring money from your HSA to your checking account in the amount of the initial QME.  For example, if you incur a $50 expense for a doctor visit, and you pay for it in cash, you are allowed to transfer $50 from your HSA to your checking account in the future.  This functionally makes the purchase tax-free, and these credits can be carried forward indefinitely.

Why would one want to carry forward Unreimbursed QME?  For one, you are allowing your HSA to compound and grow.  Due to the contribution limitations, each dollar in your HSA is somewhat valuable.  Paying medical expenses out of pocket protects your HSA, allowing it to grow from the highest possible base.

Additionally, carrying forward Unreimbursed QME allows you access to cash when needed.  If an emergency occurs, you can cash in your Unreimbursed QME credits for cash.  This is not the most ideal investment strategy, as you are reducing your principal, but sometimes emergencies require this action.  This is an advantage over accounts such as 401(k) that have a penalty for most cash withdrawals,

Cash Withdrawal w/ tax and penalty
This option is the most painful of the three, but it is still an option.  Perhaps you do not have any UQME with which to reimburse yourself.  At any time, you may make a non-qualified withdrawal from your HSA to pay for anything you want.  Basically, being non-qualified means the expense is not a qualified medical expense.  You simply ‘undo’ or take back your HSA contribution.

However, this comes at a (steep) price.  A non-qualified withdrawal invokes the following:

    1. Tax Man – This amount withdrawn is added to your current year’s gross income, which means it will be taxed.  Initially, you contributed tax free, but since you will be using this money for non qualified purchases, you must now pay tax on this.  For example, if your tax rate is 20% and you withdraw $500, you owe $100 in taxes.
    2. Penalty – Secondly, there is a 20% penalty for non-qualified withdrawals.  This amount is due to the IRS come tax time, and it is not fun.  Back to the prior example, besides the $100 in taxes, there is also a $100 penalty due.  Note:  if you are over 65, this penalty does not apply to you.  That is why an HSA is a great long term savings vehicle for the young, as you only owe income taxes on non-qualified withdrawals in your golden years.

The math shows why this option is so poor.  In our example, a $500 non-qualified withdrawal results in only $300 in your pocket.  You give away a huge percentage of your hard earned money to the government in this maneuver.  But sometimes you have no other option.

If you are at risk of having to make a non-qualified withdrawal during normal (employed) times, perhaps you are being too aggressive with your contributions.  One suggestion would be to park your HSA contributions in your emergency fund before contributing to your HSA.  Here, your money is much more liquid and you avoid penalty for withdrawing it.  At the end of the tax year, once any possible emergencies or costs have arisen, you can make a lump sum transfer to your HSA for that year’s contribution.  Contributing late in the year is far better than a 40% hit.

Conclusion
Having both a strong HSA balance and unreimbursed QME credits puts you in an advantaged financial position.  During a spell of unemployment, these provide cover for 1) insurance premiums and 2) random cash needs.  I make it one of my goals to pay all of my QME out of pocket so I can pull tax-free cash later.    This is an excellent safety net for an unexpected job loss.

In the worst case, you are prepared for difficult times.  In the best case, you have more in your HSA to compound and grow.  Get strategic with your HSA to better prepare for your future.

 


Using your HSA as an ATM

We already know that a health savings account is a terrific savings vehicle because it is triple tax advantaged, which allows you to pay for medical care with tax free dollars.  We also know that your HSA is yours forever, and that you can invest and grow your savings for long periods of time.  This presents the opportunity – given diligent savings and investment – to grow your HSA into a certified nest egg, for either medical care or retirement.

But there is another major advantage that can help you along the way.  You can design your HSA so that you can pull tax free cash from it at any time.  In this way, it acts as your own personal ATM.

Of course, there is no free lunch.  To pull money out of your HSA tax and penalty free, you must do so by reimbursing yourself for previous qualified medical expenses that you paid out of pocket.  This means that at some point in the past, you simply paid for QME out of pocket (credit card, cash, check) instead of using your HSA debit card or check.  Any QME paid out of pocket can be reimbursed from your HSA at any time, tomorrow or in 30 years.

As a simple example, suppose I go to the doctor and pay the $45 copay out of pocket. Since this is a qualified medical expense, I am entitled to reimburse myself from my HSA at any time.  This reimbursement is simply a transfer of $45 from my HSA to my checking account.  No paperwork, no taxes, no mess.  Just a simple transfer.  Tracking this by keeping proper records ensures you maximize your tax free withdrawals and don’t make mistakes.

Unreimbursed QME Credits
You can begin to see the advantage here.  The more QME I pay out of pocket now, the more I can reimburse myself for in the future.  Depending on how often I do this, I can accumulate a fair amount of unpaid reimbursements.  $25 here, $45 there, $100 the following month.  Eventually, I have a lot of cash in my HSA that I am entitled to draw from for reimbursement.

I have termed these credits Unreimbursed QME (creative, I know).  These represent amounts that I can pull from my HSA, tax free, at any time for reimbursement.  While I wouldn’t reimburse myself to purchase baseball tickets, it does serve as a backup emergency fund should such an event arise.  It is nice to have this available should I need it.  Of course, I would rather keep cash in my HSA so it can grow, tax free.

Unreimbursed QME goes back to the essence of saving and personal financial: sacrificing consumption today to enjoy a better tomorrow.

The Benefits of UQME
Paying medical expenses out of pocket isn’t necessarily fun, as it takes from my monthly budget.  At the same time, one of my goals is to pay for as much QME out of pocket as possible.  Why is this?  There are three reasons:

  1. My HSA is one of my savings accounts, and I aim to protect it.  I am much happier spending $45 out of pocket than reducing my HSA by $45.  I want that account to grow, and you can only contribute so much each year.  In my monthly budget, I have a line for HSA contributions (savings) and a line for random medical (expense).  This prevents small medical spending from chipping away at my HSA.
  2. Speaking of growing, there is a huge benefit to allowing your HSA to grow and compound.  Spending it ‘early’ reduces the amount that can compound, which limits the potential growth of the fund.  You need your money working for you for as long as possible. For example, it would be nice to keep that $100 in your HSA, invest it for 7 years, allowing it to double. Then, you can reimburse yourself with ‘the house’s’ money.
  3. Moreover, I view the UQME as a safety net.  I like the option of being able to pull cash from the HSA if I need it, with no tax implications.

Thus, whenever I pay QME out of pocket I feel good as I am protecting my HSA, letting it grow, and establishing a ‘line of credit’ that I can pull from at any time.  Hopefully I won’t need it, but it is nice to know that it is there.

I bet you can’t do that with your copays on your ‘other’ health insurance plan.

 


Breaking Down the HSA’s Triple Tax Advantage

A central theme of this site is to define the advantages of HDHP/HSA’s compared to other types of health insurance.  This is a major one.

One of the key financial benefits of an HSA is the Triple Tax Advantage, which will be covered here in detail.  Remember that an HSA is a tax advantaged savings account for medical expenses, which you can open if you have an HDHP.  Basically, your own savings account for medical expenses that you own forever and can even invest and grow.  An HSA is tax advantaged in three key areas: Contributions, Earnings, and Withdrawals.

1) HSA contributions are tax free

Similar to a 401(k), money you contribute to your HSA is pre-tax.  This means that you do not pay income taxes on the money you contribute to your HSA.  For example, if you earn $35k per year, and invest $3k in your HSA, you will only pay tax on $32k of income.  You save an amount equal to your contribution multiplied by your tax rate.

Example: $3000 contribution x 15% tax rate = $450 tax savings

Why is this an advantage – you keep more of your money you earn, instead of giving it to Uncle Sam!

How exactly is your taxable income reduced? This depends on how you fund your HSA, and there are two main ways to contribute to your HSA:

A) HSA contributions are deducted from your paycheck before taxes are paid (preferred method).  Similar to a 401(k) contribution, your HSA contribution is deducted from your paycheck each pay period, before taxes are paid:

Triple Tax Advantage - HSA contribution paycheck

As you can see, your contributions are never taxed.

B) Or, you manually contribute to your HSA using after tax money.  In this scenario, you simply transfer money to your HSA each month.  This is how I fund my HSA at HSA Bank, and I have an automatic contribution setup for $160 every month on the 26th.

Triple Tax Advantage - HSA contribution manual

 

If you manually contribute, you will need to deduct your contributions from your gross income on that year’s tax return.  When I file my taxes online, a section prompts me about my HSA contributions for the year.  That way, I ensure my contributions are not taxed.

This method takes a little more work (paperwork for taxes + performing monthly contribution), but not much.  An automated contribution plan definitely helps.  However, this method of contribution loses out on FICA taxes (article to come).

2) Your HSA earnings grow tax free

Capital gains occur when you sell an asset at a higher price than what you paid for it.  Basically, you pay tax on your profit.  With an HSA, you do not owe taxes on your interest income or capital gains that accrue in your health savings account.  Thus, your HSA can be growing and you don’t owe Uncle Sam a dime.

(Oh yeah, did you know you can invest your HSA into stocks, bonds, ETF’s, etc?)

Why this is an advantage – besides avoiding nasty paperwork, consider the wonderful concept of compound interest.  Instead of paying your investment gains out in taxes, those gains can further grow, and the gains on those initial gains can grow, wash rinse repeat.  The net result is that your portfolio will be worth more over time.  By dutifully contributing to your HSA each month, and by making long term investments, you can grow it into one heck of a nest egg for medical expenses or retirement.

Article to come on the magic of compound interest…

3) Qualified withdrawals are tax free from your HSA

You have an HSA to cover future medical expenses.  Here’s the kicker: if you use your HSA to purchase qualified medical expenses (and a lot of things qualify), you owe no tax that withdrawal.  For example, if you visit your doctor and owe $45 for the visit, you can pay using your HSA debit card, or reimburse yourself for that cost (transfer from HSA -> checking account).  There is no paperwork to be filed and no tax to be paid for that withdrawal.  Heck yeah, no taxes!  So you contributed tax free, it grew tax free, and it can be withdrawn tax free.

Why this is an advantage – you are spending tax free money on medical expenses.

That is how the Triple Tax Advantage adds up: by not paying income taxes on contributions, earnings, or withdrawals, you effectively pay for medical expenses with tax free money.  There are very few places I can think of where you outright avoid paying taxes on your income, which is one of the reasons why the Triple Tax Advantage is a strong piece of the HSA advantage.

In summary, the Triple Tax Advantage reduces your income taxes for a year.  That means you pay less to Uncle Sam and keep more in your pocket (via your HSA).  Additionally, it provides a vehicle for tax-free investment growth.  This is a huge advantage when you consider the ill effects of capital gains taxes on a portfolio over many years.  You can take advantage of this vehicle to create an account that not only covers all of your medical expenses, but also serves as a backup retirement account, should you be so lucky.  Do not underestimate the power of compound interest over many years of contributing.