The ultimate retirement account isn’t technically a retirement account.
If used wisely though, it could be one of the best places to put your money when saving for early retirement.
So what is it?
It’s a Health Savings Account (HSA).
An HSA is a tax-advantaged savings account available for people who are enrolled in a high-deductible health insurance plan.
Since people with high-deductible health plans could face more out-of-pocket costs (due to the higher deductibles), the government provides tax incentives to motivate people to save for those expenses.
HSA account holders can contribute pre-tax dollars to the account and can then withdraw money from the account, tax free, when paying for qualified medical expenses.
Warning: Do not confuse HSAs with other health-related accounts like FSAs and HRAs because they are very different and definitely aren’t as good. This article is about HSAs only.
HSAs are Super IRAs
The HSA is billed as a savings account for health expenses but it’s really the Clark Kent of retirement accounts because it’s actually a super IRA in disguise.
Why is it a super IRA?
Before answering that, let’s first briefly touch on some of the benefits of the various types of retirement accounts.
These are the most common retirement accounts (e.g. 401k, 403b, Traditional IRA) and are great for two reasons:
- Your contributions to these accounts are pre-tax contributions. This means that you don’t pay any income tax on the money you contribute. For example, if you make $100,000 a year but contribute $15,000 to your 401(k), the IRS treats you as if you only made $85,000.
- The money in these accounts is able to grow tax free.
You eventually have to pay tax when you withdraw money but since you receive a tax break when you put money in and the money is able to grow tax free, it is usually worth maxing out these accounts to take advantage of these benefits (see why I think these accounts are best for early retirees).
Taxation on Traditional Retirement Accounts
Tax-free-withdrawal accounts (e.g. Roth 401k, Roth IRA) are different because they require you to pay tax on your income up front but the money grows tax free and you do not have to pay any tax when you withdraw the money after you reach the age of 59.5.
So using the salary in the above example, if you contribute $5,000 to a Roth IRA, you will still initially pay tax on your full $100,000 salary but you won’t have to pay any tax when you withdraw the money from the Roth.
Taxation on Roth Retirement Accounts
For most of the population, an HSA is simply a savings account for medical expenses that provides some tax benefits.
Since you’re a smart Mad Fientist reader though, I suggest you disregard the medical aspect of the account and simply think of it as a special retirement account that you are able to contribute to when you are enrolled in a high-deductible health plan.
When used intelligently, the HSA can potentially provide the best benefits of both a Traditional IRA and a Roth IRA because you are not only able to contribute pre-tax dollars, like you can with a 401(k)/403(b)/Traditional IRA, but you can still enjoy the tax-free growth and tax-free distributions that a Roth provides!
That means you could potentially have tax-free contributions in, tax-free growth, and tax-free distributions out. Or in other words, completely tax-free money!
Taxation on Health Savings Accounts
The best part is, you can take the distributions whenever you want (assuming you’ve had a qualifying medical expense after setting up the account) so this can be used to fund your early retirement!
Delaying HSA Distributions
Since there is no rule stating that you must use your HSA to directly pay for medical expenses or that you must withdraw money from your HSA within a certain amount of time after paying for a medical expense, you can just take out the money whenever you want.
As long as the qualified medical expense occurred after the HSA was opened, you can withdraw money from the HSA at any time after incurring the expense to reimburse yourself.
Let’s assume that I only spend $200 a year on medical expenses. It doesn’t make sense to pay a lot of money for an expensive full-service health insurance plan, since I rarely go to the doctor, so I instead decide to get a cheaper high-deductible health plan (HDHP) with a lower monthly premium.
Since I have an HDHP, I am able to open a health savings account so I elect to max it out with $3,450 every year and I invest the account’s money in a total stock market index fund.
Because contributions to the HSA are pre-tax, depositing $3,450 into my HSA decreases my taxable income by $3,450 and therefore reduces my taxes.
When I go to the doctor, I can pay for my $200 yearly visit with my tax-free HSA funds directly but if I instead pay with cash or my normal credit card, I am able to withdraw that $200 from my HSA at a later time (to pay myself back for the qualified medical expense).
The great benefit of having an HSA is that I can decide when to pay myself back. Since I am already maxing out my other tax-advantaged accounts and have ample savings, a $200 payment isn’t going to break the bank so there’s no rush to get paid back from my HSA. Instead, I am able to leave that $200 in my HSA to grow tax-free until I decide to withdraw it!
As long as I keep my receipts (and make digital copies, in case the physical copies wear out), I can withdraw the money for qualified medical expenses from my HSA at any time, in a similar way a retired person over age 59.5 can withdraw money from a Roth IRA – tax free!
So to summarize, I have saved myself from paying income tax on the $3,450 of income I used to fund the HSA, I now have $3,250 that is growing in the account tax free, and I have another $200 that is in the HSA growing tax free that I can withdraw whenever I want to!
Bonus: To keep track of how much of your HSA can be withdrawn immediately, click here to download a free copy of the spreadsheet I used on my own journey to financial independence!
Worst Case (or Best Case?) Scenario
I can hear you saying, “What if I put all this money into my HSA but I don’t have any health issues…how will I ever get my money out?”
In this case, the account will simply act like a Traditional IRA but with an increased distribution age (65 instead of 59.5 for a Traditional IRA).
Like a Traditional IRA, your contributions to the HSA are pre-tax contributions and your contributions are allowed to grow tax free. If you don’t use your HSA funds for medical expenses, you can begin withdrawing money from your HSA account for any expenses after you turn 65, without penalty. You’ll have to pay income tax on any distributions…