yeah, that's a great strategy if you're already rich and healthy and life falls according to your plans.
We put our expected annual med expenses in an HSA at the credit union (2.5 percent). When we reimburse out of that, we invest that money in tax-deferred. We're getting double the tax deduction, which is worth a lot more than tax-free growth to us. I rarely hear anyone talk about the double tax deduction.
How does this work out mathematically?
Assumptions:
* You have $7,000 of pre-tax income to allocate.
* You have $2,000 of expected medical bills that have to be paid out of this $7,000 somehow. The rest can go to savings.
* Married filing jointly.
* You can't afford to max out all of your available tax shelters.
* Current tax bracket: 12%.
Option 1: Put it all in the HSA, withdraw medical expenses in the same year, leaving the rest in the HSA.
Here you put all $7,000 in the HSA and pay your $2,000 medical bills directly from that account, leaving you with $5,000 of HSA money.
Option 2: Run the medical bills through the HSA, invest the rest in a pre-tax retirement account.
Here you put $2,000 of your pre-tax money in the HSA, withdraw it to pay your medical bills, leaving $5,000 to put in your pre-tax retirement account.
Option 3: Skip the HSA, invest the rest in a pre-tax retirement account.
Here you need to pay tax on the amount you pay for medical bills, so that eats up $2,272.73 of your pre-tax income. You're left with $4,727.27 to put in the pre-tax retirement account.
Can we agree that Option 3 is strictly worse than Option 2?
Now, you could come up with an Option 2a where you put the retirement savings in Roth instead of pre-tax, but that just reduces the problem to a question of whether it's better to go with pre-tax or Roth in general. That has already been discussed ad nauseum elsewhere.
Some possible confounding factors:
* If HSA contributions are made through payroll deductions as part of your employer's health plan, you'll generally avoid paying payroll tax on these. Not so with 401(k) contributions. This is a point in the HSA's favor.
* If you would get an employer match by making the pre-tax retirement contributions, that's a point in the retirement account's favor.
I would argue that Option 1 is probably better than Option 2 most of the time. The nominal amount of dollars saved is the same either way. The question is how these dollars will be taxed upon withdrawal.
With the HSA money you'll pay no tax if you withdraw an amount that is less than your out-of-pocket medical expenses going forward (including COBRA premiums and Medicare premiums). If you withdraw more than this you'll pay tax at your regular rate, plus 20% if you're under 65.
With the retirement account money you'll pay tax at your regular rate whenever you withdraw, plus 10% if you're under 59½ and haven't done something like the Roth conversion ladder to avoid the 10% early withdrawal tax.
With the HSA the path to tax-free withdrawals is clear: incur qualifying medical expenses. Basically the only way to avoid this is to be perfectly healthy until you get hit by a bus prior to age 65 and pronounced dead at the scene, meaning no hospital bills or Medicare premiums. For this to happen to both partners in a marriage is extremely unlikely. Even if this
does happen, the difference for your heirs is just that they have to tax a taxable distribution of the full amount in the year of your death rather than stretching these distributions out over a number of years.
With the retirement account the path to tax-free withdrawals is also pretty clear: convert or withdraw less than your standard or itemized deductions. The standard deduction isn't all that large though. Most of us will probably be spending more than this in retirement. In that case it's nice to have a source of funds (such as an HSA or Roth principal) to tap into tax-free once we hit the top of our desired tax bracket.
You may want to avoid contributing so much to your HSA that its annual growth is likely to outpace your Medicare premiums by age 65 if you remain healthy. Until that point, the HSA is pretty appealing. There's a reason that our standard
investment order recommends maxing out an HSA before making unmatched retirement account contributions. I agree with this reasoning wholeheartedly.