Set Your Kid Up With a Health Savings Account (HSA)

Kids who are no longer their parents’ tax dependents (or anyone else’s dependent for that matter), can open their own Health Savings Account (HSA), and anyone can contribute to it.

Back in December 2020, I penned a blog discussing Health Savings Accounts (HSAs) as a potential additional retirement investment vehicle. It stirred a bit of conversation (and questions) among my subscribers, which encouraged me to elaborate a bit about how you can set up an HSA for your kid(s). But first, let's review HSAs in general. NOTE: Since I’m not a credentialed financial advisor, the answers (observations) I give are strictly my opinion.

High Deductible Requirement

In order to open an HSA you have to be covered by a high-deductible health insurance policy. What does that mean? The minimum deductible qualification to use an HSA is $1,400 (individuals) or $2,800 (families), which can be hard for many folks to meet…or cause them to skimp on needed healthcare. Simply put, an HSA might not be for you.

For an HSA to be meaningful, you’ll need spare cash to take advantage of its…well…advantages – cash to pay the big deductible and other healthcare expenses out of pocket to avoid raiding the HSA.

Trio of Tax Advantages

An HSA offers three tax advantages:

Contributions to an HSA are tax deductible.
HSA contributions grow tax-deferred.
Withdrawals from an HSA aren’t taxable as long as the money is spent on “qualified” medical expenses. The IRS has a list of those expenses and no double-dipping is permitted should eligible expenses have been covered by a Flexible Spending Account or health insurance policy. In case you’ve forgotten, withdrawals from other tax-advantaged accounts…traditional IRAs, 401(k)s, etc.…are taxed as income.

Don't Use It, Don't Lose It

Unlike “use it or lose it” Flexible Spending Account year-end balances, which is the other tax-advantaged medical plan (that allows a maximum contribution of $2,750 in 2021), HSA balances at year’s end can be rolled into the next year…and the next…

Why is this a big deal? Because they aren’t forfeited like FSA contributions, HSA funds build up over time and can be invested just like funds in an IRA or 401(k). Thus, the $3,600 per annum contribution by an individual or the $7,200 by families, plus the $1,000 catch-up for folks over 55 can be invested long-term.

Even if you have to spend some bucks occasionally on deductibles or medical expenses along the way, that residual tax-free growth can add up by retirement age.

Tax-Free Withdrawals

Again, withdrawals from HSAs are tax-free if used for qualified medical expenses, including those high health insurance deductibles and co-payments. And get this, the IRS does not require folks to incur the expense in the same year the withdrawal is made…so long as the expense occurred after the HSA was opened and funded.

In short, there is no statute of limitations on when you reimburse yourself for eligible medical expenses. How’s that for flexibility? But keep those faded receipts in case your steely-eyed IRS agent comes calling.

As noted, the money must be spent on qualified health-care expenses… BUT NOT AFTER YOU TURN AGE 65! At that point, withdrawals can be made or any reason, but if the money is not used for qualified medical expenses they will be treated as taxable income… but without the typical 10% penalty. In short, over age 65 HSA withdrawals are treated the same as withdrawals after age 59 ½ from a traditional IRA or 401(k).

Kid HSAs

NOW let's talk about how you can help your kids get their own tax-advantaged retirement plans going. Generally speaking, you can’t claim your youngsters as dependents after age 19 (or 24 if college students), but many kids are covered under their parents’ high-deductible health insurance policies until age 26.

Use it as an opportunity to financially assist your “aging” youngsters. Children who are not dependents for tax purposes yet who are still covered by their parents’ high-deductible health plans can set up their own HSAs. Parents can help their kids out by providing some or all of the money to fund such accounts. In short, if children are no longer their parents’ tax dependent (or anyone else’s dependent for that matter), they can open their own HSA, and anyone can contribute to the child’s HSA account. However, and no surprise here, once children are no longer dependents, their expenses can’t be used for tax-free withdrawals from a parent’s HSA.

This particular strategy under HSA rules avails adults of tax deductions for such contributions – and potentially, decades of tax-advantaged investment growth. This is an amazing and unique opportunity for young adults to take advantage of the Amazing Power Of Compounding early in life.

In Sum

I hope this helps clarify the many advantages of an HSA…or eliminates further consideration of such a vehicle in the absence of a high-deductible health insurance policy.

For those it fits, what a great way to expand tax-advantaged opportunities – for yourself and perhaps for those of your qualifying kids!