How an HSA Works, and Why You Can Invest It

What is an HSA?

A health savings account (HSA) is an account for medical costs that you can have with a high-deductible health plan. Money goes in before tax, grows tax-free, and comes out tax-free for qualified medical expenses. Unlike a flexible spending account (FSA), it never expires, it stays yours when you change jobs, and you can invest it.

A friend told me recently that they knew all about an HSA's tax breaks, and even the trick of keeping receipts to pay yourself back later, but had no idea the money could be invested. I think that's the most common thing people miss about HSAs, so it gets its own section below.

Who can have an HSA?

You need a high-deductible health plan (HDHP), and generally no other health coverage. You also can't be enrolled in Medicare or be claimed as someone else's dependent. The minimum deductible that counts as "high," and the other rules, change from year to year; the IRS's Publication 969 (opens in a new tab) has the current ones.

Your employer may offer an HSA alongside its high-deductible plan, sometimes with a contribution of its own. If not, you can open one yourself.

What are the three tax breaks?

1. Going in: money you put in through payroll skips income tax and Social Security and Medicare. (Put money in on your own and you deduct it on your tax return instead.)
2. While it grows: interest and investment gains aren't taxed.
3. Coming out: withdrawals for qualified medical expenses are tax-free.

Here's what that first break is worth. Say you're in the 12% federal bracket with a flat 5% state tax. Every $100 you put into your HSA through payroll costs you only about $75 of take-home pay, because it skips income tax and the 7.65% for Social Security and Medicare. That's better than a traditional 401(k), where the same $100 costs about $83, because 401(k) money still pays Social Security and Medicare.

There's a yearly limit on how much can go in, counting your employer's contributions too. It usually rises each year; the IRS lists the current limits (opens in a new tab).

HSA vs. FSA: what's the difference?

Both let you pay medical costs with pre-tax money, but they work very differently:

	HSA	Health FSA
Who can have one	People with a high-deductible health plan	Anyone whose employer offers one
Money you don't spend	Stays in the account, every year	Use it or lose it, apart from a small carryover or short grace period, if your plan allows one
Can you invest it?	Yes, usually once your balance passes a minimum	No
If you leave your job	It's yours	It usually stays with the employer

I've never had an FSA myself, so that column comes from the rules, not experience. The short version: an FSA is for spending this year; an HSA can be for spending this year or for decades from now.

Can you invest your HSA?

Yes, and it's the step most people miss. Many HSAs start out as plain cash, earning little or nothing, and stay that way unless you choose investments.

Here's how I set mine up: I keep a cash balance of roughly my yearly deductible, and anything above that moves into investments automatically.

I'll be honest about one more thing. I like taking on more risk with my HSA: when the market is down, I shift toward more growth-oriented funds and stocks, and when it's normal or running hot, I shift toward more conservative target-date funds. That's my personal preference, not advice. I think most people should stick with safe, "set and forget" options and not try to manage or time them: live your life, wake up in 20 to 40 years, and the money's waiting for you, stress-free.

To see what "set and forget" can do: $100 a month, invested at a 7% yearly return (an example, not a promise) for 30 years, grows to $113,352.94. You'd have put in $36,000.

Should you spend it now or let it grow?

You can do either. I normally pay medical costs out of pocket and let my HSA grow. I have spent from it, though: I bought a RingConn, a ring-style health tracker, with HSA money. Not every gadget counts as a qualified medical expense, so check your plan and IRS Publication 969 before you buy.

If you pay out of pocket, keep your receipts. Qualified expenses from after you opened the HSA can generally be reimbursed later, which is the "pay yourself back" trick my friend knew about.

What if you use it for something that isn't medical? Before 65, you'd pay income tax plus an extra 20% tax. From 65 on, the extra 20% goes away, and you'd just pay income tax, much like a traditional 401(k). Medical withdrawals stay tax-free at any age.

Why it matters

If you're eligible, an HSA is one of the few accounts with a tax break going in, while it grows, and coming out. It's one of the options worth weighing after you've got your 401(k) match. And like a 401(k), money taken out of your paycheck before it reaches your bank account saves itself without you having to remember.

This is educational, not financial or tax advice. For a decision this personal, consider talking with a tax professional or financial planner.

What to take with you

• Check whether you qualify: an HSA needs a high-deductible health plan.
• Contribute through payroll if you can, so the money skips income tax and Social Security and Medicare.
• Invest it. Keep enough cash for your deductible, and put the rest to work.
• Keep it simple: for most people, a safe "set and forget" option beats trying to time the market.
• Save your receipts if you pay medical costs out of pocket.
• Know the FSA difference: an FSA is use-it-or-lose-it; an HSA keeps growing.

Want to see how your savings could grow? Try the compound interest calculator.