Recently, I’ve been reading some FIRE blogs about using your HSA for college, instead of using it to pay for medical expenses, so I set out to determine which is better. Is an HSA best used for paying your kiddos college expenses, or is it best used for paying for medical expenses?
I previously covered the rules of an HSA here:
$500,000 + 6 Reasons you need a Tax-Free HSA Today
Let’s do a quick recap.
- You must have a qualified High Deductible Health Plan
- You can’t be on Medicare
- There are annual contribution limits
The rules (besides #2) are all summed up in this handy table.
Tax Benefits of an HSA
- Contributions are Pre-Tax Dollars
- Growth is Tax-Free
- Withdrawals are Tax-Free
Potential HSA Savings over time
Also, a quick reminder of how much you could potentially save up in your HSA if you maxed it out every year.
Note: Interest column if for the single year only. Not cumulative.
As you can see, the potential is quite large. And it’s all tax free!
HSA for College
How to use HSA savings for college
The whole idea is based off of this one HSA caveat:
HSA savings can be used to pay prior year’s medical expenses, as long as the HSA was created before the expense occurred.
The idea is that you invest money into your HSA each year, invest it, and let it grow until your little one out grows you and is ready to go off to college. At which time, you gather all your medical receipts, and exchange those for your HSA savings.
The primary reason why people do this is to not have their money stuck in a college savings account, where they would be penalized for withdrawing the money if the kid does not go to college. But there is more than one benefit, given the right circumstances.
Hidden from FAFSA calculations
The money you have invested in your HSA is excluded in the parental asset calculations. When you withdrawal the HSA savings, it does not count as income. These two factors result in a lower EFC (Expected Family Contribution). A lower EFC could result in more financial assistance, or even receiving grants.
For this to work best, you must be low income and have money invested in the right places. If you make too much money, or have lots of money invested in certain accounts, this approach won’t really have an impact on your EFC.
There is a whole 36-page guide published annually on how the EFC is calculated. The link seems to change frequently, so I’ll just suggest searching for “The EFC Formula guide”. Here is a brief list as it related to this article.
What Counts and Doesn’t Count towards EFC
- Taxable Income
- Checking & Savings accounts
- Education Savings (529 Savings, ESA)
- Roth IRA withdrawals
- HSA Savings
- Home Equity
- Retirement savings (mostly)
Assumptions made Or Possible Problems with the college savings option:
1. You have an HSA and are eligible to contribute
In order for this HSA college savings plan to work, you’re going to have to have an HSA and be able to contribute to it every year. In order to do that, you must have a High Deductible Health Plan (HDHP). And the most common place where people get HDHPs are through their employer. That means having a job. It is possible to find qualifying HDHPs in the open market, but you will pay a premium.
2. You can afford to pay medical bills out of pocket
Just like any other investment, you have to let it sit there and grow over time. That means paying the medical bills from some other source, which is probably funded from your paycheck. If your fortunate enough to not have to worry about paying medical bills, you’re probably fortunate enough to be able to pay for college.
3. You actually have medical expenses
Lastly, you have to have a decent amount of medical bills by the time your kid goes off to college. And don’t forget, you have to pay them out of pocket. There are a lot of things that count as medical expenses, such as sunblock, but hitting $7,000 or so every year is a lot of health expenses, especially for a healthy person.
Consider that the average in-state tuition per year at a public university was $9,970. Valuepenguin.com provided a more in-depth breakdown of the tuition figures.
Also consider that tuition has been rising at a rate faster than the rate of inflation. While $7,000 today would cover a good chunk of the tuition, it will not have as much purchasing power in 18+ years.
College Saving Alternatives
If you’re wondering what tax advantaged alternatives there are to using an HSA, here are the ones I know about. 529 plan is what I personally use, and I don’t endorse the other two options.
These plans have no annual contribution limits, and really high maximum contribution limits (Think in the $400,000 range). The only requirement is the money is used for qualified higher education expenses or K-12 qualified tuition expenses. There is a 10% penalty if money with taken out for unqualified expenses. The beneficiary can be change to certain other family members
Similar to a 529, but with more restrictions. There is a $2,000 per year contribution limit and the owner of the account must have an adjusted gross income less than $110,000 (for the year 2020).
If you use a Roth IRA withdrawal for qualified education expenses before age 59 1/2, you will avoid the 10% penalty, but you will still pay income tax on the earnings portion.
HSA for Medical Expenses
Common Place Method
The most common way I see an HSA being used is to pay for medical bills as they come in using HSA savings first. Only after the HSA is depleted do you pay out of pocket.
Here is what putting money into an HSA will save the average person each year. Let’s take a look at the saving of someone who makes an average American income (+/- $48,000 AGI), and therefore falls in the 22% tax-bracket.
This is actually the method I used to follow, but changed course in favor of this next method after doing my homework. Also, I can afford to pay out pocket, so far.
Make the max contribution to your HSA each year, invest it, and let it grow. Let the power of compounding do its work.
This is the same as what you would do with saving money in the HSA for college, only it’s not ear-marked specifically for college. Also, you have a longer horizon to let the money grow, instead of having to take it out when your kid goes to college. The later years are when compounding makes your money grow the fastest.
Save your HSA for when you get Old
Typically, your largest medical expenses are when you get old. Here are the stats.
This is the most recent data available from Centers for Medicare & Medicaid Services. I created the table from a downloadable spreadsheet that you can find on their website at CMS.gov
You can see that medical bills are largest for those over age 85, but considering the average American lives only 79 years, let consider the next highest category, those age 65-84. If you started investing in your HSA at age 20, you could potentially have 2.5 million saved up for health costs. That should be enough to cover everything, I’d hope. Even If you weren’t able to start investing in your HSA until 30, meaning you invested in the HSA for 35 years, you would still have over a million. Not bad. (Reference above table for numbers)
If you curious about your probability of living to a certain age, the Social Security Administration publishes an Actuarial table for life expectancy. Check it out here.
Now if you had chosen to use the HSA money to pay for your kids’ college, and were able to invest the max for 18 years, you would have had a total of about $270,000, having earned about $150,000 in interest. Not terrible, but not nearly as fun as earning $2 million in interest, and having a huge pile of money for when you need it.
The Best Option (Conclusion)
Having reviewed all of this information, and having some time to run over the numbers, here is the answer to my initial question of, “Is an HSA best used for paying your kiddos college expenses, or is it best used for paying for medical expenses?”
My best advice is to invest your money in the following order. This will allow for the most tax savings, assuming you kid goes to college (which I am assuming).
1. Use multiple tax-advantaged accounts
Save tax on money invested in the HSA as well as save taxes for growth on money in the 529 plan. Not using the 529 plan would be leaving money on the table.
2. Order of Investing matters
If you have a limited amount of money that you are able to put towards your HSA and 529 plan, be sure to max out your HSA first!
Funding your HSA should come before funding any type of tax advantaged college savings account. Really, it should come before any type of account, except your 410(k) with an employer match.
The reasoning is that an HSA is triple (quadruple) tax-advantaged. Putting money here will save you the most money as far as taxes are concerned. There is no other place where your money is completely tax free!
Once the HSA is maxed out, then contribute to the college savings. The money goes in after taxes, but the growth is tax-free.
3. Save HSA money as long as possible
If you can afford to pay medical bills out of pocket, do it. Save HSA money as long as possible, while saving all your medical receipts along the way. Make digital copies of the receipts and store originals in a safe place.
You can then use the HSA money however you see fit, and it will be there in case you ever need the money. Perhaps it could be used for paying insurance premiums, which is not usually considered a qualifying expense.
I realize my situation doesn’t fit everybody. If you want to read the case against the 529, read this post by GoCurryCracker