Can You Save Too Much in a Health Savings Account?

Health savings accounts were far from an overnight sensation. George W. Bush signed the legislation that allowed for HSAs in 2003, but by the end of that first decade, the accounts had still gained only about $10 billion in assets.

But HSA assets have taken off since then, mirroring the growth of high-deductible healthcare plans at large. (To take advantage of an HSA, one needs to be covered by a high-deductible healthcare plan.) At mid-2020, assets in HSAs approached $74 billion, a 19% increase from the year prior, according to a report from HSA consultant Devenir.

Most assets in HSAs aren't invested in the market but rather are parked in savings accounts to cover out-of-pocket healthcare expenses. But assets in HSAs that are invested in long-term securities have grown rapidly, too. Devenir reported that HSA investment assets had increased by 32%, to more than $17 billion, in the one-year period through June 2020, and the average HSA balance was more than $15,000. 

Those HSA investors are no doubt attracted to the accounts' prodigious tax benefits--the ability to make pretax contributions, enjoy tax-free compounding, and take tax-free withdrawals to pay qualified healthcare expenses. In fact, based on the tax merits alone, HSAs are more attractive than other retirement-savings vehicles like IRAs and 401(k)s.

But can you overdo your HSA contributions--put more in the account than you're likely to spend on healthcare costs? The short answer is that it's unlikely, largely because HSAs have generous features around withdrawals. In a worst-case scenario where your HSA account balance exceeds your expected healthcare costs, you have two key ways to get your money out sooner without negating the tax benefits of the HSA.

Escape Hatch 1: The Paper Trail
If you're using your HSA as an investment vehicle, a cardinal principle is that it's better to use non-HSA assets to cover healthcare expenses. After all, taxable assets don't enjoy the same tax benefits that assets sitting inside an HSA do, so if you have the wherewithal to use taxable assets to cover your healthcare costs instead, that lets the assets inside the HSA enjoy tax-advantaged growth.

The good news is that even if you're pursuing this strategy, you're not locked into it. If you paid out of pocket (using non-HSA assets) for healthcare expenses in previous years, you can still make a tax-free withdrawal later on for nonhealthcare expenses, provided you hung on to receipts for the earlier healthcare costs. An unlimited amount of time can elapse between when you actually incurred the healthcare cost and when you reimburse yourself; the withdrawal will be tax-free as long as you have the proper documentation of the prior expense.

To use a simple example, let's say a person paid $5,000 out of her taxable monies to cover healthcare expenses incurred at the end of 2019. Throughout 2020, she racked up the maximum family contribution of $7,100 in her HSA, letting the money build up rather than spending from it. If she needed a new roof in December 2020, she could pull $5,000 from her HSA to steer toward that expense (an amount equal to her outlays for healthcare), and that withdrawal would be tax-free provided she could document the 2019 out-of-pocket healthcare costs.

That's not ideal, of course, because she's better off letting the money grow. But a tax-free HSA withdrawal beats other forms of emergency funding, such as credit cards, home equity lines of credit, or 401(k) loans. The key to preserving this escape hatch, as noted above, is to maintain scrupulous documentation of healthcare expenditures. It's also worth noting that the HSA participant must have established the HSA and made the contribution before she incurred the healthcare cost.

Escape Hatch 2: Withdrawals After Age 65
Once you're past age 65, withdrawals for nonhealthcare expenses are even more straightforward. You can withdraw from your HSA for any reason at that life stage.
If the withdrawals are for nonhealthcare expenses, they'll be taxed exactly as an IRA or 401(k) withdrawal would be. In other words, you'll pay taxes on your withdrawal, but you've been able to take advantage of a free ride on taxes (pretax contributions, tax-free compounding) up until that point. That flexibility makes the HSA a perfectly viable ancillary retirement savings vehicle.

It's also worth noting that people who are over 65 can knit this and the aforementioned strategy together. Even if you used non-HSA assets to cover your healthcare expenses and leave your HSA money undisturbed until age 65, you could pull the money out tax-free for any reason, provided you've saved your receipts for the healthcare expenses you covered out of pocket in the years before that.

Just Don't Leave It Behind
Yet even as HSAs allow for withdrawals for nonhealthcare expenses under certain conditions, it's also important to spend through HSA assets in retirement. That's because inherited HSAs don't have the same tax flexibility that IRAs do. If a spouse is the beneficiary of an HSA, he or she can maintain the account as an HSA and continue to take advantage of those generous tax benefits. On the other hand, if someone other than the spouse is the beneficiary of the HSA, the HSA and its attendant tax benefits cease to exist upon the death of the original HSA owner. That means the inherited amount is fully taxable to the beneficiary. Given those drawbacks, that suggests that HSA owners with a nonspouse beneficiary (or a spouse beneficiary with a limited expected life span) prioritize HSA withdrawals.

Those rules also suggests that HSA investors give due consideration to the beneficiaries of their accounts. While naming a spouse as a beneficiary can make a lot of sense, the last surviving spouse might consider expediting expenditures from the HSA (at least to match healthcare spending) and/or naming a charity as the HSA beneficiary. In contrast to an HSA inherited by a human beneficiary who's not a spouse, the charity wouldn't owe taxes on the inherited amount.