Ah, retirement! Traveling, volunteering, or just being happy not having to work. Whatever your retirement dreams are, paying for medical expenses is usually not one of them. It should be, though, because health care will be a significant cost. A health savings account (HSA) could be the ticket to enjoying your retirement savings the way you want while also saving taxes.
“You are going to have to take on the financial burden of health care.”
Health care costs are a daily news item. Employer retiree coverage is disappearing. Out-of-pocket costs are soaring, and the ability to retire before Medicare eligibility is becoming more complex. You’re probably sick of hearing it, but the fact is most people are unprepared for the costs.
The HSA Facts
An HSA is a medical expense account only available to those enrolled in a high-deductible health plan (HDHP). What is an HDHP? In 2023, A plan with a deductible of at least $1,500 for an individual or $3,000 for a family with a max out-of-pocket expense of $7,500 for an individual and $15,100 for a family.
For 2023, individuals can contribute up to $3,850, and families, $7,750, plus an additional $1,000 a year if you’re 55 or older. You can make prior-year contributions until April 15, just like an IRA.
Beyond the HDHP requirement, you also cannot contribute to an HSA:
- After you enroll in Medicare
- If you contribute to a Flexible-Spending Account (FSA) unless the FSA is for a “limited purpose” such as vision or dental expenses.
“Cannot contribute” does not mean “cannot own.” It is possible to own an HSA when enrolled in Medicare or no longer a participant in an HDHP. That is an essential fact in the overall strategy.
If you’re one of the increasing numbers of people with an HDHP, you are in luck. An HSA is a deceptively powerful tool with numerous benefits.
1. HSA distributions are tax-free for qualified medical expenses
Did you know you can reimburse yourself for medical expenses incurred years before, provided the medical expense was accrued while the HSA was open? There isn’t even a time limit, but you can’t reimburse expenses incurred before you had the account.
For example, let’s say you just opened an HSA, and there’s a balance of only $2,000. It was a rough year, and you had an unexpected medical expense of $20,000. You can use the $2,000, and then you can take distributions and reimburse yourself for that $20,000 medical expense in future years. There’s no time limit, so you can reimburse yourself over ten years if you need to.
What about if you retire before 65 and purchase a stand-alone health care plan? Although you can use the HSA to pay for deductibles, copayments, coinsurance, and some other expenses, an HSA funds may not be used to pay premiums.
How about Medicare? Even though your Medicare premiums are paid through Social Security benefits, you can use your HSA to reimburse yourself for those expenses. You can use HSA money tax-free to pay premiums for Medicare parts B and D and Medicare Advantage plans (but not premiums for Medicare supplement policies) along with other out-of-pocket medical expenses.
A nonqualified distribution is subject to income tax and a 20% penalty. Unless…
2. The HSA retirement income option
Once you reach age 65, you can withdraw money from an HSA for any purpose, not just medical expenses, and not be subject to the 20% penalty. You will have to pay income tax on nonqualified distributions. However, I don’t recommend this, especially since you’ll have Medicare expenses anyway.
3. HSA can sit there and grow until the cows come home
Unlike an FSA, there’s no use-it-or-lose-it rule. You can keep on contributing money until you need it. The entire balance carries over and grows, year, after year, after year (Hint, Hint). Again, you can even retroactively reimburse yourself for previous expenses, as long as the HSA was open and you still have your receipts.
4. Investment options
HSA accounts can be invested just like a retirement account. That can be good or bad. The decision to invest depends on how soon you’ll need the funds. If you know you’ll need the funds within the next few years, it’s wise to keep it in cash.
5. You Own your HSA
An HSA goes with you, even if you retire, are fired, or just quit. That’s not the case with an FSA. Your FSA account does not belong to you; it’s your employer’s. When your employment ends, so does the FSA (Note: you can still use it if you purchase COBRA). That’s a little nugget of info most people don’t realize.
6. Transfer/Rollover Options
HSA to HSA: Unfortunately, HSAs often have high fees for maintenance and other charges that reduce their benefit. The good news? There is a way to get out of a high-cost HSA by regularly rolling over the HSA assets into a lower-cost plan of your choosing.
There are two ways to do this. The first is a direct transfer from one HSA to another. You can do direct transfers multiple times yearly without being subject to taxes. The second is a rollover, where the HSA sends you the funds, and then you forward the funds to the new HSA custodian. You are allowed one rollover per year.
IRA to HSA: The IRS allows a once-per-lifetime transfer from an IRA account to an HSA, but the amount, combined with other HSA contributions for the year, may not exceed your maximum annual contribution.
7. Triple the fun
HSAs are one sweet savings option. Contributions to them are tax-free, the investment earnings grow tax-free, and the funds can be withdrawn tax-free anytime when used for qualified health care expenses. Triple-tax advantages like this don’t come down the pike very often.
Let’s not forget that after age 65, contributions and earnings can be withdrawn for any reason without penalty. However, income tax rates apply, and there are no Required Minimum Distributions (RMDs) at age 73.
Yes, I mentioned these benefits earlier, but I think they are so beneficial they deserve a second shout-out as a retirement savings tool.
Putting it all together
When you compare HSAs to IRAs, Roth IRAs, 401(k)s, Roth 401(k)s, heck, even 529s, they stand up well. Taxes in those plans are assessed either going in or going out, some have RMDs, and 529s can only be used for education regardless of age.
The average couple, age 65, will spend $260,000 on health care in retirement. (Fidelity)
The trick is knowing how to make the most out of your HSA. Looking at the benefits of an HSA with an eye toward retirement, it’s like a lightbulb being turned on. Let’s assume you can contribute $4,000 to an HSA annually for 20 years and earn a conservative 3% annual return. That would give you approximately $110,000.
If you spend $5,000 on all health and medical expenses each year and have an effective tax rate of 18%, you’ll save over $900 per year, and I think I’m lowballing the amount you’ll spend. The more you spend, the higher the tax benefit. Don’t forget I did not include the tax benefit when you contribute to an HSA.
If an adverse medical condition would require significant resources in retirement and require withdrawals from an IRA or 401(k), there is a possibility those withdrawals would push you into a higher tax bracket. An HSA could prevent that.
There would be income tax due to the withdrawals for non-healthcare expenses after age 65, but no penalty. Worst-case scenario, you would use the HSA like an IRA without the required minimum distributions. That’s not the end of the world.
If funds remain in your HSA when you die, the account will go to your spouse and become theirs, or if you’re not married, it will cease being an HSA and pass to your beneficiary.
An HSA is a win-win situation
Most people don’t have the resources to use their HSA as a retirement savings tool. To think that you won’t ever need any of your funds for medical expenses isn’t realistic. An HSA will help you cover medical expenses without depleting emergency funds or using credit cards. That’s a win in my book.
The key is to balance your current needs with an eye to the future. Keep a portion of your HSA assets in cash to cover short-term needs, and invest the rest in a mix of stock and bond funds for the long term.
Everything in financial planning comes down to cash flow. The more you can save in a tax-efficient manner before and during retirement, the more significant your financial benefit. An HSA is a unique tool that can accomplish that goal and prepare you for the cost of health care in retirement.
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