How to Leverage Health Savings Accounts to Fund Expenses in Retirement

As we age, health concerns arise increasingly frequently.  Especially in retirement, covering rising medical costs can be a big concern.  Fortunately, if you prepare ahead of time, there are powerful tools to incorporate into your overall financial plan that can help you to cover rising medical costs.

One of the best options to consider adding to your portfolios is called a Health Savings Account (HSA).  If you qualify to establish and fund an HSA, you can get many benefits that can significantly improve your financial plan and ability to cover medical costs in retirement.

Introduction to Health Savings Accounts

According to the Employees Benefits Research Institute, the average U.S. couple will need over $300,000 to cover out of pocket health-care costs in their retirement years.  Compared to the average retirement plan balance, this is a significant amount for most families.

HSA’s are less than 20 years old, a key reason why many financial advisors and their clients have not really begun to take advantage of the many benefits that HSA offer when used properly in a comprehensive financial, investment, and retirement plan. 

In order to help American’s address the growth in medical costs, Congress established HSA’s in 2003 as part of the Medicare Prescription Drug, Improvement and Modernization Act.   HSA’s are evolved from and have some advantages over Flexible Spending Accounts (FSA). Unlike a FSA, the dollars in your HSA account can accumulate and roll over if unused from one year to another.  In contrast, the biggest drawback of FSA accounts that limited their appeal was the use-it-or-lose-it nature of FSAs.  Any money not used in one year was effectively lost thereafter.

Health Savings Accounts, or HSAs, continue to grow in awareness and popularity.  Today more than $60 billion in assets is held in HSA accounts, and this has grown over 10x since 2010.

Not everyone is eligible to establish an HSA.  In order to qualify to contribute to an HSA, you must be enrolled in a high-deductible health-insurance plan and have no other health coverage.  You also must not be claimed as a dependent by anyone else.

A High Deductible Health Insurance Plan in 2020 is defined as a health insurance plan with a deductible of at least $1,400 if you are an individual and $2,800 if you are a family.  In addition, the total out-of-pocket expenses including deductibles, copayments and coinsurance payments cannot be more than $6,900 for an individual or $13,800 for a family.

Note, that many medical insurance plans offered by employers are not qualifying high deductible plans (if you are not sure, ask your employer or insurance provider).  Because they don’t understand the many benefits of having an HSA, many employees and even business owners actively avoid higher deductible insurance plans because they prefer to pay more for plans that cover more of their upfront medical costs.

However, by choosing a high deductible health insurance plan, you will typically be charged lower monthly or annual insurance payments (to compensate you for taking on the high upfront deductible exposure), and just as importantly, it also qualifies you to establish your own HSA and then put funds into the HSA as well.

The funds you put into a HSA are tax deductible.  This means that the money you put into the HSA is deducted from your taxable income thereby reducing your tax bill in the year that you make your contribution to the HSA.  In 2020, the maximum contribution amounts are $3,550 if you are an individual and $7,100 if you are a family.  For individuals aged 55 or older, you are also allowed an additional catch up contribution of $1,000 for each individual up to a maximum of $9,000 as a family.

Depending on where you establish your HSA, you can invest the money in your HSA into growing or income producing investments.  Additionally, the earnings you accrue in the HSA account accumulate tax-free. When you need to use the money for qualifying medical expenses, you can withdraw from the HSA tax-free.  Notice that because of this triple combination of upfront tax deduction, tax-free growth, and tax-free withdrawal for medical expenses, HSAs are a rare and very valuable tool in the right hands. 

HSA accounts vs IRA accounts and 529 plans

Traditional IRAs, for example, allow for tax deductible contributions and tax deferred growth, however, money when withdrawn is taxed at your full federal and state income tax rate which can be around 40% or even higher. 

Roth IRAs do not give you a tax deductible contribution, however the growth and the withdrawals are tax free giving you 2 out of the 3 benefits of an HSA.

529 Plans for qualifying educational expenses do not give you an upfront tax deduction, though the growth and the withdrawal are tax free if used for education expenses. 

Notice, that it is only HSA accounts that give you the triple tax free treatment when used for qualifying medical expenses.  Fortunately, most people as they age can anticipate significant future medical expenses, so an HSA account, if you qualify, can be applicable and create a major benefit for most families who opt for a high deductible health plan during their open enrollment period.

Qualified medical expenses are essentially any that would qualify for a medical expense deduction. They include, but are not limited to doctors visits, hospital stays, nursing services, surgical expenses, hearing aids, medical equipment, eye care and long-term service care.

How HSA’s Work

HSA’s are meant to cover costs that are not covered by your health insurance plan. Some employers that offer high-deductible health plans also offer HSAs.  Either way, you can open a separate HSA account either with your employer or choose from any qualified HSA custodian as long as you have a qualifying high-deductible health insurance plan. Each year, you make a decision as to how much money you wish to put into your HSA, up to the government-mandated maximum.

The best way to open a Health Savings Account is to establish it at an HSA custodian or HSA provider. There are many HSA custodians you can choose from.  Some of the points to consider in choosing an HSA provider include account minimums or fees charged, investment options available and the size and reputation of the custodian firm.

Based on our research, there are multiple good HSA custodian options.  One of the higher rated options is the Fidelity HSA custodied by Fidelity Investments because Fidelity is a well established firm and their HSA has good investment options and no account minimums or fees.  If you already have an HSA at one custodian, you can also transfer that money directly into another HSA without any issues or adverse tax consequences.  Many HSAs are held at banks, however, that treat the HSA funds as low interest earning deposits.  If this is the case, these HSA owners could often be better off moving these bank custodied HSAs to other firms like Fidelity with a broader range of investment options and greater flexibility and higher earning potential.

Who Can Benefit From HSA’s?

You can benefit from having an HSA if you can anticipate having out-of-pocket health-related costs at some point during your lifetime.  Another benefit is that HSA’s are quite flexible. You can use the dollars in your account to pay for current medical expenses or save the money for future needs. You also control how much money to contribute to the account and which medical expenses to pay from the account and how to invest the money to help it grow.  If you need investment or financial guidance to help you, you can work with an experienced advisor such as Ridgewood Investments to help you along the way.

Tax Advantages Of Using HSA’s to Fund Health-Related Expenses in Retirement 

In addition to providing a means for saving for future health-care costs, HSA’s have three wonderful tax advantages. The contributions are deductible, they can grow free of taxes, and in many cases, these funds can be withdrawn tax-free if used for or to reimburse past qualifying medical expenses. 

Keep in mind that if you are younger than 65 years old, you must pay income taxes and a 20% penalty if you withdraw or use funds from your HSA for anything other than qualified health-related costs.  This is why you should only use HSA funds for qualifying medical costs especially prior to age 65.

Upon reaching the age of 65, additional powerful provisions come into effect. For example, certain insurance premiums can be paid tax free with HSA distributions after you reach age 65 and enroll in Medicare. 

Note that once you reach age 65, which is when your Medicare benefit starts for most Americans, you then become ineligible to make further contributions to your HSA. Unlike traditional IRAs where you need to begin making withdrawals at age 72 and beyond, you are not required to begin withdrawing HSA funds at any age.  Therefore, if you can afford to defer withdrawals for a significant amount of time, you can do so with an HSA,

After age 65, as long as you use your HSA funds to pay for (or to reimburse yourself for) qualifying medical expenses, there is no tax on the withdrawal from your HSA.  After age 65, if you use the funds for anything other than qualifying medical expenses, that portion will be taxed to you as ordinary income.  Distributions that you take from your HSA after age 65 are never subject to penalty, no matter what you use the funds for after age 65. 

Advanced HSA Techniques and Strategies

As you can see, HSA’s enable you to save pre-tax or tax-deductible money, enable it to grow tax-free, and then to use the account to cover medical costs free of any taxes. In addition to these main benefits, there are several advanced techniques and strategies with which you will want to familiarize yourself.

Rollover from your IRA

Currently, the rules allow you to make a one-time tax-free and penalty-free rollover from your Traditional or Roth IRA to fund a HSA. If you are considering this option, it would be better to rollover from a Traditional versus a Roth IRA. This is because with a Roth IRA you would be rolling over money for which you’ve already paid income taxes, unlike the deductible contribution made to a Traditional IRA.  Remember that if you rollover from an IRA you are still subject to the maximum contribution limit each year, however, taking that portion from your IRA into an HSA can turn some of that Traditional IRA money that would be taxed upon withdrawal into a tax free distribution if used for qualifying medical expenses.  Unfortunately, you can only do this one time in your lifetime under current rules.

Shelter from Social Security and Medicare Taxes

A lesser-known strategy regarding HSA’s is the ability to avoid paying Social Security and Medicare taxes on pretax contributions. This is not the case with many other qualified, tax-deferred plans such as 401k’s.

A Roth IRA or Retirement Plan Supplement

The over-65 provisions that enable tax-free for medical expenses and penalty-free withdrawal for any reason essentially make HSA’s into a pseudo Roth IRA-like vehicle, but one without any maximum income eligibility limits such as with the actual Roth IRA. Thus, savvy investors with high deductible health insurance plans can fund these instruments in their working years with an eye to using them as a supplemental source for retirement expenses/withdrawals later in life.

Defer withdrawals from HSA for as long as possible.

Even if you have an HSA (sometimes also called the Stealth IRA), it can be a good idea to leave the funds in the HSA to accumulate on a tax-free basis as long as possible.  One strategy even if you have accumulated significant funds in your HSA is to pay all of your out of pocket medical expenses from other sources.  However, save all these payments and receipts in one place (or scan them).  Some of the HSA custodians have phone apps that do this for you.  Many years later (if you have saved the receipts and records) you can reimburse yourself the full amount on a tax-free basis while your money was growing tax-free in the HSA the whole time!

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