In order to reach your wealth-building goals, selecting the right kind of investment account is as important as choosing an appropriate asset allocation. By taking advantage of tax-favored accounts, millennial investors can supercharge their nest eggs.
An often overlooked but powerful wealth-building tool is the health savings account. Contributions to an HSA are tax-deductible, and investment gains and withdrawals are tax-free when used to pay for qualified medical expenses. That's a triple-tax advantage, which is amazing.
The result is the growth of an account that is truly tax-free. HSAs are relatively new, established by Congress in 2003, so millennials are the first generation uniquely positioned to take advantage of HSAs so early in life.
To be eligible for an HSA, you must be covered by a high-deductible health plan. An HDHP has lower premiums than a traditional health plan, but comes with a higher deductible. This means you pay less each month for health insurance, but potentially more out of pocket when you go to the doctor. Millennials can be excellent candidates for high-deductible plans because we tend to go to the doctor less and have lower medical expenses in general.
HSAs can be great for all ages, but particularly so for millennials who have decades for the investment to grow. Most people use the HSA like a savings account and spend it down each year on medical expenses.
Instead, to build wealth, you should view it as a long-term investment. You might keep a portion of your HSA in cash in case of an emergency, but otherwise, for maximum effect, it can pay off to invest the rest of your account for growth.
If eligible for an HSA, you can take full advantage by contributing the maximum allowed each year. In 2019 the contribution limit is $3,500 if you have individual health coverage, or up to $7,000 if you're covered by a family plan.
An HSA can also be an opportunity for "free money," as many employers offer matching contributions. These employer contributions do count toward the annual limit, but unlike a flexible spending account, or FSA, an HSA is not "use it or lose it," and the account stays with you even if you change jobs.
The HSA is flexible in that you can pay yourself back at any time for expenses incurred in previous years, and there is no time limit for reimbursement. So, when you do go to the doctor, try to pay out of pocket for most services, and track these expenses on a spreadsheet. Scan your receipts into a file and download your Explanations of Benefits (EOBs) from your insurer. You'll need these records later to take tax-free reimbursements.
Later in life, you can use these accumulated tax-free reimbursements toward other goals such as sending your kid to college or buying a new boat. And you can feel good knowing that, along the way, you left this money invested and working for you, and it grew the balance in your account.
Because you can reimburse yourself at any time without tax or penalty, the HSA has the flexibility to help fund an early retirement. Or, as is more typical, this pot of money becomes part of your nest egg. Health-care costs are on the rise, and we tend to incur more health-related expenses as we get older, so an HSA also serves as a tax-free way to pay for health-care in retirement, including Medicare premiums.
There is, however, one big trap with an HSA: If you take money out before age 65 for reasons other than a qualified medical expense or reimbursement, the distribution will be taxed and you'll incur a hefty penalty from the IRS equal to 20 percent of the amount withdrawn.
The good news is that, after age 65, you can make withdrawals without the penalty, although non-qualified withdrawals will still be taxable as ordinary income. In this way, it operates just like a pre-tax individual retirement account or 401(k) plan after age 65. It's always best to keep good records, and to earmark your withdrawals toward eligible expenses for tax-free withdrawals.
It's important to identify the goal for each dollar you invest, and to align your investment strategy to your objectives. Evaluating what type of account to use ultimately depends on how the IRS treats the account for tax purposes.
Some retirement accounts, such as traditional IRAs and 401(k) plans, are "pre-taxed." That means the IRS gives a tax deduction for contributions, but you'll pay tax on the back-end. Other accounts, such as the Roth IRA or Roth 401(k), are "after-tax," meaning there's no deduction for contributions, but then distributions are tax-free because you paid the tax up-front.
The HSA is the best of both worlds. When used properly, it's the best way to build truly tax-free wealth by making tax-deductible contributions, investing the account for growth over time and taking tax-free distributions and reimbursements later in life.
The HSA is more flexible than it seems, and can be the Swiss Army knife your portfolio needs.
— By Tyler Landes, founder and president of Tandem Financial Guidance
Disclosure: NBCUniversal and Comcast Ventures are investors in Acorns.