These things are freaking magic.
Before I start, I need to point out that I am talking about Health Savings Accounts (HSAs). There are similar things like FSAs and HRAs that often get confused with HSAs. Those aren’t magic. Only the HSA is magic.
Those other things might be useful and you should seriously think about using them, but they aren’t magic.
What A HSA Is
A health savings account lets you put in money tax free. Depending on the plan type and your preferences, you can either have a payroll deduction into it or you can put in after tax money and get the taxes paid back when you file your taxes for the year.
The amount in the HSA rolls over from year to year, it doesn’t go away at the end of the year like some other accounts (FSA, etc) does.
Once The Money Is Inside
Once the money is in there, depending on the plan, your money gets invested somehow. Good plans allow you to self direct how to invest the money that goes in and they have good investment options like Vanguard Index Funds.
Getting The Money Back Out
The plan will also give you some way to access this money, like a debit card that you can pay with at a doctor’s office. You will have to have enough in cash to equal the charge. This will probably require selling investments equal to the incoming charge.
Then you just slide the card and pay the expense.
Note 1, the IRS might ask you to prove that money withdrawn from the account was used to pay for medical expenses. That means you need to save receipts.
Note 2, you CAN spend this money on something stupid like beer, but if the IRS makes you prove that you used this money on medical bills and you can’t prove that, then you are going to be hit with steep penalties like you wouldn’t believe. Try your regular tax rate plus 20% additional. Do not do this.
Luckily for you, we humans tend to need medical care at some point during life.
If You Don’t Ever Need Medical Care
If you don’t, it’s still not a waste. If you get to retirement age and you don’t have medical expenses, you can still take it out and spend it on whatever like it was coming out of a 401k. The withdrawal rules for HSAs are very similar to 401k withdrawal rules except that if the money gets spent on medical bills then there is never any tax. That’s a benefit 401ks for sure don’t have.
Unfortunately, not just anybody can setup an HSA. You can only do it if you have a High Deductible Health Plan (HDHP). What qualifies as a high deductible changes every year, but for 2016 the requirement is a deductible of 1300 for one person or 2600 for two or more people.
If you don’t have a HDHP, you can’t contribute to an HSA.
If you begin an HSA and you change your insurance, you must stop contributing to the HSA until such a time as you are again covered under a HDHP.
There are also limits to how much you can put in and they are a lot lower than 401k limits are. For 2016, those are 3350 for one person or 6750 for two or more people.
According to my analysis, you should contribute any amount necessary to get an employer match inside a 401k. After that point, if you can put money into an HSA, you should seriously consider doing that before adding more to the 401k.
It’s very likely that we will have medical expenses in life and the last thing we want when we have a medical expense is not to be able to pay it.
People that have all of their money inside a 401k often run into a liquidity crisis. That means you have a lot of money, but you can’t access it when you need it.
The HSA takes a lot of that away. The withdrawing is similar to 401k except better when you have unexpected medical expenses. Or even expected medical expenses. If you have an HSA and you get a medical expense, then you should withdraw the money from the HSA and pay it with pre-tax dollars.
Now, say you have enough money in cash to just pay the medical bill and you do that. Say that you also fall within the income category that lets you contribute to a Roth IRA (a post tax account). Withdraw from the HSA equal to the bill anyway and put the money in a Roth IRA. The net result of this is funding a Roth IRA with pre-tax dollars.
Read that last paragraph again. Read it a third time. There aren’t very many ways you can do this.