A Taxing Question on HSAs

Health Savings Accounts, or HSAs, are tax-advantaged savings accounts that are paired with a high deductible health plan (HDHP).

The idea is to take on a HDHP and put enough money into a MSA, so as to have money to pay for both expected and unexpected health care expenses.

Contributions to HSAs can be done via pretax earnings, thereby saving or at worst delaying the tax that otherwise would be paid (if withdrawn for nonmedical use after age 65, the non-earnings part of the distribution would be taxable). Earnings on contributions accumulate taxfree, even if withdrawn for nonmedical use after age 65.

So here is the question. Suppose someone is in an HDHP and puts the maximum amount, $3100, into their account. At the end of the year, they see that they have incurred $1000 of health care expenses, and begin to prepare a withdrawal from the HSA to repay themselves.

But...those funds in the HSA are earning taxfree returns. Suppose the individual has maxed out on all other tax-advantaged investment opportunities, such as their IRA.

Then why take any funds out of the HSA? The person should really just eat the health care expenses out of regular savings or income. Leave that HSA alone and let it accumulate taxfree!

The question then is: One might have thought ex ante that, with the HSA, the marginal cost of health care expenses would be lower by the marginal tax rate, that is, if the marginal tax rate is 30%, then the real cost of health care expenses will only be 70 cents per dollar incurred. But if one is behaving optimally, it seems that one should just put the maximum contribution into the HSA and leave it there for retirement...or for general living expenses, health care included, if any kind of cash flow situation develops.

So the cost of health care seems to be dollar for dollar, at the margin, just like for any other consumption. The fact that the HSA is funded with pretax dollars is just a gift from the government in general; it is not a means for lowering the marginal cost of health care.

This is different from Medical Reimbursement Accounts, which are funded with pretax dollars but cannot roll from year to year and do not earn returns. With MRAs, the money has to be spent on health care, and they do lower the marginal cost to the consumer of health care only.

Is this right? Will consumers see this pricing difference and behave differently with HSAs than MRAs -- purchasing less health care? My bet is yes: Come the end of the year, and people start thinking about withdrawing from their HSA to pay for health care, some of them will realize they are better just leaving the money there. Others will have used their HSA on a pay-as-you-go basis, since they come with a debit card sometimes. These people will be foregoing a very nice way to save tax free for retirement. Of course, many people are not currently maximizing their opportunities to save taxfree for a variety of reasons.