Health Savings Accounts (HSAs)

If you're on a high-deductible healthcare plan (a “HDHP”), you might have access to an HSA. An HSA is a tax-advantaged account that can be used to pay for healthcare expenses. The investment options vary between providers, but it's often possible to invest the money in an HSA in a variety of fairly low-fee index funds.

The HSA happens to be a fantastically great investment vehicle. Contributions to an HSA (capped at $3,400 for an individual in 2017) are deductible, the money isn't taxed as it grows, and it can be withdrawn tax-free, too, but only to pay for medical expenses.

However, there's a trick! Withdrawing money from an HSA incurs a 20% penalty tax if the money isn't used for qualified expenses… until you turn 65. After that, the money can be withdrawn tax-free and used for anything, like a Roth IRA.

This means that, bizarrely enough, an HSA is a better retirement vehicle than either a 401(k) or an IRA. Contributions are tax-free, growth isn't subject to capital gains, and after 65 you can withdraw from it tax-free.

Flexible Savings Accounts (FSAs)

Don't confuse HSAs with FSAs! An FSA is, ironically, a bit like a less flexible HSA, which expires after a year.

If you have a health insurance plan with an FSA, you can contribute a certain amount of money every year, tax-free, into the account. That money must be used for medical expenses, and if it hasn't been used by the end of the year, poof! It's gone. Up to $500 can now be rolled over from year to year—courtesy of the Affordable Care Act—but any amount in excess of that is forfeited.

Funding an FSA correctly requires you to accurately predict your future medical expenses. This isn't always possible, of course, but if you have regular expenses (like a prescription) it's often possible to estimate your costs fairly closely and take advantage of the tax deduction. Similarly, if you have a procedure coming up in the next year (finally gonna get those adult braces!), you can fund your FSA to cover that.

What if my plan offers both?

If you've got the cash available, here's what I'd suggest:

  • Fully fund your HSA. Don't withdraw from it unless necessary; just think of it as an IRA.
  • Fund your FSA to cover any predictable medical expenses. Err on the side of under-funding, since it's better to miss a tax break than to pay a penalty or lose the cash.

If you don't have the cash to sufficiently fund both, I'd suggest prioritizing your HSA. They have the same tax benefits, but money in the HSA will persist from year to year.

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