Using a Health Savings Account (HSA) as a Retirement Planning Vehicle
Kevin Michels, CFP®, EA
With premiums and deductibles on health insurance policies rising in tandem, the growth of Health Savings Accounts (HSA) has exploded over the past few years.
Health Savings Accounts were created in 2003 as a way for individuals and families, who were covered by a high-deductible plan, to receive tax-preferred treatment on money saved and earmarked for medical expenses. If used for medical expenses, an HSA could provide a triple-tax benefit.
#1 – Tax Deductible Contributions
The money you contribute to an HSA is tax-deductible. However, like an IRA, there is a limit to how much you can contribute to the account. In 2018, an individual can contribute and deduct up to $3,450, while a family can contribute and deduct up to $6,900.
#2 – Tax Deferral on Investment Income
Once you contribute to an HSA, you have the option to invest your money or keep it as cash. If you decide to invest, the income generated by your investments (capital gains, dividends, and interest) are all tax-deferred, similar to an IRA.
3# - Tax-Free Withdrawals If Used for Medical Expenses
When you tap your HSA to pay for medical expenses, the withdrawal is tax-free, similar to a Roth IRA. The list of qualifying medical expenses is long and inclusive, however there are a few expenses an HSA shouldn’t be used to pay for, including health insurance premiums, funeral expenses and most cosmetic procedures such as ear piercings, face lifts, or laser hair removal. If you end up taking a withdrawal from your HSA for non-medical expenses, not only will you pay ordinary income taxes on the withdrawal, but you’ll also pay a 20% penalty.
While Health Savings Accounts can be a great tool to save and pay for current medical expenses, the popularity of HSA’s is growing among those preparing for retirement.
That’s because, upon turning age 65, you can use money saved in an HSA for anything, without incurring the 20% penalty. Essentially, your HSA acts like a Traditional IRA for non-medical expenses. Any withdrawals for non-medical expenses are taxed at ordinary income rates, while qualified medical withdrawals still retain the tax-free treatment as before.
In addition to the triple-tax benefit of using an HSA for current medical expenses, we’ve seen the use of an HSA as a retirement savings account solve three additional retirement planning problems:
#1 – HSA’s Have No Income Limit or Earned Income Requirement
In order to prevent high-income individuals from benefitting too much from available tax breaks, lawmakers have put restrictions on who can deduct contributions to a Traditional IRA and who can contribute to a Roth IRA, based on income. In 2018, if you file married filing jointly, are covered by a retirement plan at work, and make more than $119,000, you aren’t eligible to take a deduction on a contribution to a Traditional IRA. If you make over $199,000 you aren’t able to contribute to a Roth IRA (directly) whatsoever. For high income individuals looking to save in tax-efficient ways for retirement, these rules make it hard to find good options. However, HSA’s don’t have income limits on who can make contributions making it a great alternative for those who exceed the income limits attached to a Traditional or Roth IRA.
#2 – HSA’s aren’t subject to required minimum distributions
Upon turning age 70, money sitting in pre-tax accounts such as a Traditional IRA or 401(k) become subject to Required Minimum Distributions (RMDs). RMDs force you to withdraw a certain percentage of your account value each year, in order to force taxation on some portion of your tax-deferred money. For many retirees, this might not be an issue, because they need to take withdrawals from their IRA to fund expenses anyway. However, for people who may not depend on the money in their IRA, or don’t need to take as much as the IRS requires them too, RMDs can result in unnecessary income and drive up their tax liability. Unlike Traditional IRAs, HSAs aren’t subject to RMDs which allows retirees to keep their money protected from taxation within the HSA as long as they want.
#3 – HSAs ease the burden of rising medical expenses in retirement
It’s no secret that medical expenses increase in retirement. The older you get, the more ailments, injuries, and sicknesses you are prone to. Fidelity Investments, which has been tracking retiree health care costs for more than a decade, estimated that a 65-year-old couple retiring in 2013 would need about $240,000 to cover future medical costs. That takes into account all medical expenses including deductibles, copayments, premiums, prescriptions, and other costs Medicare doesn’t pay for such as hearing aids and eyeglasses. As a retiree, medical costs can turn into your biggest expense and can force you to take more from your retirement accounts than you would normally need. Medical expenses are inevitable and having money sitting in an HSA to cover those expenses tax-free makes a huge difference. Assuming just a 20% average tax rate on $240,000 in withdrawals results in $48,000 of additional taxes. If the $48,000 that you pay in taxes were left to sit and grow at a 6% rate within a tax-deferred account, it would grow to $275,000 over 30 years!
Health Savings Accounts are great tools to save and pay for medical expenses now but can be equally beneficial as a retirement savings vehicle.
Many of you may not qualify for an HSA, simply due to the fact that you aren’t covered by a high deductible health plan. However, if you do have a HDHP and you haven’t looked into an HSA yet, now is the time to do it. To end, a few rules to abide by if you do end up using an HSA:
- If you plan on funding on HSA to cover expected medical bills in the near future, don’t invest your contributions and subject them to market risk.
- If you plan on funding an HSA for retirement, make sure you set it up with a company that provides quality investment options. Health Equity is a company based here in Utah that offers a wide variety of Vanguard funds to invest in.
- And last, make sure to stay informed regarding the news and updates surrounding HSAs. Our country is currently in a health insurance crisis and any future legislation to help fix the problem will most likely include some type of changes or updates to HSAs.