Key Points
Taking a non-medical withdrawal from a health savings account (HS) typically triggers a 20% penalty.
Once you reach a certain age, that penalty goes away.
For this reason, it pays to max out your HSA, or contribute as much as you can.
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A lot of people use flexible spending accounts, or FSAs, to sock money away for healthcare costs in a tax-advantaged manner. But FSAs, despite their name, aren't as flexible as you'd think.
With an FSA, you generally need to use up your plan balance each year or risk forfeiting money you've saved. That's why health savings accounts, or HSAs, have a huge advantage over FSAs.
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With an HSA, the money you put in never expires. You can fund an HSA in your 20s and take withdrawals in your 50s to pay for qualifying medical expenses.
HSAs also offer far more tax benefits than FSAs. With an HSA:
- Contributions are tax-free
- Investment gains are tax-free
- Withdrawals taken for qualifying healthcare expenses are tax-free
FSAs do not give you the option to invest your money. And so you don't get that second tax benefit.
You may be hesitant to contribute too much to an HSA, though, for fear of having too much money accumulate in that account over time. Since HSA withdrawals taken for non-medical purposes are subject to a 20% penalty, that's understandable.
But you should know that there's really no such thing as overfunding an HSA. Here's why.
Understand how HSAs work later in life
Many people are inclined to treat as HSA as a short-term spending account, using it to cover copays or deductibles as they arise. But the best way to make the most of an HSA is to pay for near-term medical bills out of pocket, invest your plan balance, and carry that money forward into retirement.
That way, your money gets many years to grow tax-free. It can also then help you cover healthcare expenses at a time when your income may be lower due to not working.
Plus, healthcare costs tend to rise with age. So the larger an HSA balance you're able to carry into retirement, the better.
Now you may be worried about having too much money in your HSA by the time retirement arrives. But here's a lesser-known HSA rule that should negate that concern.
Once you turn 65, you can take an HSA withdrawal for any purpose without incurring a penalty.
If you use those funds for qualifying medical expenses, they'll come out tax-free. If not, you'll pay taxes on your withdrawals, the same way you'd pay taxes on distributions from a traditional IRA or 401(k).
But starting at age 65, your HSA is yours to use however you please without penalties. So it's worth maxing out HSA contributions every year, or getting as close as possible.
An account that gives you a world of freedom
You may consider an HSA a fairly restrictive account since it's designed to help you pay for medical expenses. But because HSA funds don't expire, and because penalties for non-medical withdrawals go away at 65, these accounts are actually more flexible than you might think.
So go ahead and fund that HSA if you're eligible, and don't worry about having too much money build up. Once you get to retirement, you may find that there's no such thing as having too large an HSA balance on your hands.
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