Health care can often be a boring financial topic. But I admit I was excited to learn about Health Savings Accounts and the triple-tax advantage that makes them a favorite investment vehicle in the personal finance community. I’ll take any opportunity to save money in a tax-protected account, and HSA offers just that.

Finally, I had an answer for what to do with my money after maxing out my annual Roth IRA and 401k contributions. Using an HSA as another retirement account? Count me in! Then I learned that California and New Jersey tax HSAs in a way unlike other states. This new bit of information took the wind right out of my sails.

What is a Health Savings Account?

Several smart bloggers have already taken a deep dive on the subject of Health Savings Accounts. Start with Mad Fientist’s strong HSA endorsement and Financial Samurai’s excellent list of HSA pros and cons (he takes an alternative view against using HSAs as a retirement account) for more information on the ins and outs of HSAs.

Rather than try to sum it up myself, I’ll use Mad Fientist’s brief explainer:

When used intelligently, the HSA can potentially provide the best benefits of both a Traditional IRA and a Roth IRA because you are not only able to contribute pre-tax dollars, like you can with a 401(k)/403(b)/Traditional IRA, but you can still enjoy the tax-free growth and tax-free distributions that a Roth provides!

That means you could potentially have tax-free contributions in, tax-free growth, and tax-free distributions out. Or in other words, completely tax-free money!

Sounds great, right? As long as you pay out of pocket for any health expenses as they occur (and keep your receipts!), you can let your pre-tax dollars grow tax free. You can also take tax-free distributions when you eventually turn in those receipts after years and years of growth. In addition to up to $19,000 of annual pre-tax 401k dollars, and $6,000 of Roth IRA contributions benefitting from tax-free growth and distributions, you have an additional $3,550 in tax-advantaged investable income to compound over the course of your working life. That’s a grand total of $28,550 of tax-advantaged money each year!

HSAs compared to FSAs

A couple important distinctions: Even though this becomes a retirement account for our purposes, you are still free to use the money from your Health Savings Account without penalty for qualified health expenses. In a medical emergency, you can absolutely draw from this “retirement account.”

It’s also important to note that HSAs differ from another common acronym, the FSA (Flexible Spending Account). FSAs are tax advantaged, but any money you put in must be used in the same year. It’s basically an anti-retirement account.

Still on board? Great. Now let’s make sure we have access to a high deductible health plan (HDHP) and set ourselves up for some triple-tax advantaged retirement action! That is, unless we live in California or New Jersey.

Wait, what?

Why do California and New Jersey Tax HSAs?

Unlike the other 48 states, California and New Jersey tax HSAs at the state level. That means you do not reap the same benefits on your state income taxes as you do federally. And there’s no apparent reason for it.

For federal income tax purposes, you will receive those triple-tax advantages. In these two states, though, you’ll have to pay state income taxes on your contributions and any capital gains from investments inside of your HSA. To make matters more infuriating, we’re talking about the #1 (California) and #6 (New Jersey) highest state income tax levels in the country. That’ll take a healthy chunk out of our intended investment vehicle.

If you do your own taxes, you’re left with a bit of a mess as a result. Since the federal and state requirements differ, there’s a bit of self-reporting required, as The Finance Buff gets into here with an in-depth breakdown of the tax ramifications.

Using Bonds in your HSA

By including treasury bonds in your HSA, you can duck some of the state tax. Treasury bonds are state income tax exempt. But by including bonds, you are sacrificing potential gains in stocks. The low interest rates you’ll receive on bonds compared to stocks make them less advantageous to own in tax-advantaged accounts. These treasury bonds will return much less than the expected annual return of an index fund such as VTSAX.

I keep VTSAX in my Roth IRA, where it stays exempt from state and federal capital gains taxes. I can assume an annual rate of return of 7-10 percent, tax-free. In most states, I could keep VTSAX in an HSA with the same tax protections.

Ultimately, owning bonds inside an HSA may not be a big deal for you. Unless you’re shooting for a very aggressive 100 percent stock allocation as I am, you’ll be just fine with the bond portion of your portfolio residing in an HSA.

Like I said, Treasury bonds will help you duck some of the tax. Even this solution, though, comes with some state tax paperwork. As The Finance Buff explains:  

Due to the additional tax complexity when you have an HSA as a California resident, some people suggest investing the HSA money only in Treasury bonds or Treasury bond funds.

Interest paid by Treasury bonds are exempt from state income tax. Limiting yourself to only Treasury bonds or Treasury bond funds will spare you from worrying about paying California tax on the earnings inside the HSA. But, it won’t make it any easier for capital gains. Capital gains on Treasury bonds or Treasury bond funds are still taxable by California. You still have to track all your purchases and your sales. You will have more tracking when you reinvest interest.

So we’re looking at added tax homework even with the suboptimal investments for an aggressive investor. Is that enough to turn me off to the crown jewel of FIRE blog hacks? Maybe.

HSAs as a retirement account

As The Financial Samurai concludes in his opposition of the HSA as a retirement account, if you’re maxing out your 401k and your Roth IRA, the HSA is small potatoes. You shouldn’t get too wrapped up in the additional $3,550 of tax-advantaged annual income in the grand scheme of things. He suggests using your Health Savings Account exactly as intended and enjoying an excellent and accessible HMO or PPO instead.

But potential loopholes like this are what make personal (and impersonal!) finance nerds alike giddy about saving for retirement. And personal finance should be fun! Right? But because California and New Jersey tax HSAs, they are taking a big bite out of this potential carrot as a method of achieving financial independence.

So, is there any hope that these states get on board and conform with federal income tax laws?

Will California And New Jersey Ever Conform To Federal Tax Law?

The answer is, perhaps. If Alabama can do it, surely there must be hope for our last two holdouts. Bama’s HSA Conformity Bill, which went into effect in 2018, left only California and New Jersey behind.

What’s encouraging, or maybe discouraging, is that progress had been made in California. In fact, legislation was introduced in February to conform to federal law on the issue. Even better: it was poised for discussion on March 20!

Now the bad news. The conformity bill was derailed by the exact sort of global pandemic that might talk me out of a HDHP to begin with.  

For several thousand reasons, we’re all hopeful that the real issues of the world abate in the near future. Not the least of which is to regain our ability to be fake mad at the nitpicky differences in state and federal tax law. And when we do return to normalcy, Californians should be ready to flood your local representatives with calls to ensure that this legislation doesn’t get lost in the shuffle of reopening society.

Whether you agree with utilizing the HSA as a retirement account or not, you should want this bill to pass. If you do in fact have a Health Savings Account in California or New Jersey, these state income tax laws are costing you time (if you do your own taxes) and money (whether or not you do your own taxes). These anomalies in two states that already have a high cost of living—and subsequently high state income taxes—are prohibiting your path to retirement. Or worse yet, limiting your affordable health care options.

Now is as good a time as any for California and New Jersey to seriously consider following the lead of their 48 brethren of this United Health Savings Account States of America.

God bless the HSAs of the US of A.