Saving money is often mentioned as one of the core steps toward financial success. Also important is deciding where to save money, as there are numerous options to consider. 401(k)s, IRAs, Roth IRAs, nonqualified accounts and others all have their own rules, benefits and tax implications. Among all of these, though, there is one account that may be the most valuable and, at the same time, the most overlooked: the health savings account (HSA).
An HSA is a tax-advantaged way to save money to pay for qualified medical expenses. It is available for people who are covered by a high-deductible health insurance plan and, similar to 401(k)s and IRAs, HSAs do have contribution limits set each year. While many high-income earners may find themselves ineligible for a Roth contribution or IRA deduction, HSAs have no income limits on who can contribute.
Since it is only available to those with high-deductible health plans, you must first make sure that type of health insurance best fits your situation. Ideally, high-deductible plans are for those with low health care needs, and since your health may one day dictate that a high-deductible plan is not in your best interest, it is all the more important to take full advantage of an HSA while you can.
When people think of the HSA, seldom do they think of retirement savings. Often it is used instead as a source of funds for current health care costs to be withdrawn and spent each year. This can lead to a significant missed opportunity. Unlike a flexible spending account (FSA), where funds have to be spent by the end of the year, HSAs allow account balances to roll over into future years. Because of this, along with the tax benefits and flexibility that an HSA offers, it becomes an ideal long-term investment account. Being more specific, the HSA becomes a perfect account to view as a medical retirement plan.
The HSA Offers Second-to-None Tax Benefits
A major feature of the HSA that sets it apart from other accounts is its tax benefits. Many of us are familiar with the tax savings that come with 401(k) contributions. Contributions are tax-deductible, giving us tax savings in the years that 401(k) contributions are made. This tax incentive is offered, in part, to encourage people to put enough money away for retirement. Likewise, investments promote economic growth. Therefore, as a matter of policy, the federal government offers numerous tax incentives to encourage people to save money.
Various accounts, especially retirement accounts, offer some form of the following: a tax-deduction on contributions, tax-deferral on growth, and/or tax-free withdrawals. Annuities, for instance, offer tax-deferral on growth, while most retirement accounts offer a combination of two of the three forms.
Outdoing all of these, the HSA offers triple-tax benefits:
- Tax deductions on contributions.
- Tax-deferred growth.
- And tax-free withdrawals if used for qualified medical costs.
Adding all these together can result in sizable tax savings and more money in your pocket. These tax savings would be maximized by investing the contributions for growth and not withdrawing them right away for current medical costs. When they are withdrawn immediately, the account loses one of its three tax benefits, as it is being denied the opportunity for tax-deferred growth.
For a view at the potential savings, compare an IRA and HSA, which have — up until the time of withdrawals — enjoyed the same tax benefits. At the time of withdrawals, this changes as the IRA money is now taxed while the HSA is tax-free. If both accounts were $300,000 and the owner was in the 24% tax bracket, the after-tax equivalent at that moment for the IRA is $228,000 ($300,000 – 24% tax) while the HSA has an after-tax equivalent of $300,000. This leaves $72,000 in extra tax savings due to the HSA having triple-tax benefits versus the double-tax benefit of the IRA.
The HSA Is Flexible
Along with great tax benefits, HSAs, in many instances, offer the best flexibility also. One reason is that HSAs do not have any limitations on when a health care expense is incurred and when it is reimbursed. Instead of taking money out of the HSA at the time each medical expense happens, you can use cash to pay the medical expense and let the HSA continue growing. This allows you to maximize the tax benefits by keeping money in the more tax-advantaged HSA account.
You should then hold on to these medical receipts because the HSA can be tapped at times when cash on hand may be getting tight. Since medical expenses can be reimbursed at a later time, if you need cash for living expenses, you can withdraw it from your HSA by using it to reimburse yourself for any of those prior medical costs. For most retirement accounts, withdrawing money at a time of a cash crunch is usually done by either accepting a 10% early withdrawal penalty, withdrawing Roth IRA contributions, or by taking a loan on your 401(k). For the HSA, the funds are accessible before age 59.5 if used on qualifying medical expenses.
Adding to the flexibility, the list of medical expenses that the IRS views as “qualified” is long. It includes items such as doctor visits, dental exams, lab fees and physical therapy. Other common eligible medical costs include long-term care premiums (up to a certain amount each month depending on your age) and Medicare A, B, C and D premiums. Note that Medicare supplemental premiums, like Medigap, are not eligible, though.
The Medical Retirement Account
To get the most use from the benefits of an HSA, it is best viewed as a long-term investment vehicle to help with future medical costs in retirement. It can be a missed opportunity not to approach it as such. This includes maximizing and investing contributions for growth, paying current medical costs out of pocket and saving the receipts so that you have the option to withdraw funds if life’s curveballs lead to some temporary hard times.
Positioning the HSA as a medical retirement plan will provide you with an important tool for navigating health care costs in retirement, which we all will have to some degree. As already mentioned, one of these is Medicare premiums. In fact, Fidelity estimates that the average couple will need $300,000 in today’s dollars for medical expenses in retirement. The HSA can be there, supplying tax-free withdrawals for these costs.
And, while the HSA does have a 20% penalty if funds are withdrawn and not used for qualified medical expenses, after age 65 this penalty drops off. So if you find yourself over 65 and in a situation where you need to tap your HSA and do not have enough medical expenses, the HSA can again prove its worth as the withdrawals are taxed but not penalized. In other words, you still receive the tax-deferred contribution from the years prior and all the tax-deferred growth, while only losing the tax-free withdrawal – similar to the tax benefits of an IRA. The HSA, in this situation, is now acting like an IRA tax-wise, although, making it even better, one that does not have required minimum distributions.
Summing it up, with all the benefits that come with a HSA, it can be a great option for medical expenses in retirement. Considering that you must be on a high-deductible health insurance plan to be eligible for an HSA and that such a plan may not always best fit your health situation, it is important to take advantage of the HSA when you can. In return, you receive triple tax benefits, flexibility to access it for qualified medical expenses without penalty before retirement, and, as a worst-case scenario — after age 65 it becomes, for all intents and purposes, an IRA with no required minimum distributions.
Financial Adviser, Kehoe Financial Advisors
Kevin Webb is a financial adviser, insurance professional and Certified Financial Planner™ at Kehoe Financial Advisors in Cincinnati. Webb works with individuals and small businesses, offering comprehensive financial planning, including Social Security strategies, along with tax, retirement, investment and estate advice. He is a fiduciary, ensuring that he acts in his clients’ best interests.