Using Health Savings Accounts to Plan for Retirement

As we are amid open enrollment season for 2021 workplace benefits, the Health Savings Account (HSA) is an often misunderstood and underutilized savings and investment vehicle that warrants exploration.  According to a 2019 survey of 2,200 Americans, no age group is making use of this account at a rate higher than 26%.  While you must be covered by a high deductible health plan (HDHP) and not currently on Medicare in order to be eligible, there are many benefits to using an HSA to save for both current and future medical expenses.  This article will discuss some of those benefits and articulate a retirement savings strategy for health care costs.

Account Rules

For a health insurance plan to be considered a HDHP, the annual deductible must be at least $1,400 for an individual or $2,800 for a family, with maximum out-of-pocket expenses of $6,900 and $13,800, respectively.  The deductible for any given health plan is the amount that must be paid by the covered person before any insurance benefits kick in (aside from any permanently covered services such as preventive care).  If the insurance policy meets these deductible thresholds, the policyholder can make a pre-tax contribution into an HSA in order to help pay for these higher potential annual costs than a plan with a lower deductible would normally incur.  Most employers that offer HDHPs will have a linked HSA account available through their health plan but it is also possible to open a personal HSA if covered by non-workplace health insurance.  The maximum contribution for individuals in 2021 is $3,600 while those covered by a family plan can contribute up to $7,200.  Participants that are age 55 and older can contribute an additional $1,000 as a catch-up contribution on top of the standard limit.  Some employers may make an annual contribution into employees’ HSAs as an additional benefit to help defray the cost of the high deductible plan.  However, the amount of any employer contribution also reduces the employee’s maximum contribution dollar-for-dollar, unlike employer matching on a 401(k) which does not affect the employee’s contribution limits.

Once deposited into the account, funds may be invested like other tax-advantaged retirement accounts such as a 401(k) or IRA.  The available investment options depend on the account provider but most will offer a menu of diverse investments for these accounts.  There could be a minimum account value (perhaps $1,000 or $2,000) before investment of the funds is available.  It is always possible to leave some or all of the account in cash for reimbursement of short-term expenses.

Taking Distributions          

Any qualified medical expenses incurred after the HSA was established are eligible for tax-free reimbursement.  Most accounts will issue a debit card that allows you to pay directly for qualified expenses, but you can also request a reimbursement from the account at any time after the expenditure.  There is no calendar-year provision that reimbursements must be requested in the year that the expense was paid and any balance remaining in the account at the end of the year rolls over indefinitely.  As long as you have a receipt to document the qualified expense, you can make a reimbursement withdrawal for any expense that occurred after the account was opened.  This is in sharp contrast to the flexible spending account (FSA) which carries an annual “use-it-or-lose-it” provision for contributions made into the account.  Even with the FSA grace period that allows some time in the following year to spend down the prior year’s funds, the HSA carries significantly more flexibility for reimbursements.  Also, unlike the FSA, HSAs are not tied to an employer and are portable once the employee leaves the firm.  It is important to note that HSA participants cannot also defer salary into a traditional FSA (although a dependent care FSA plus HSA is allowed).

Use As A Retirement Savings Vehicle

Given the relatively low contribution limit for other tax-advantaged retirement vehicles such as IRAs ($6,000/$7,000 per person per year if under/over age 50), the HSA can serve as a great option for additional retirement savings.  The HSA is the only qualified account with a triple tax advantage, meaning that money goes in pre-tax, accumulates investment growth over time without incurring any dividend or capital gains taxes, and is withdrawn tax-free if the distribution is for a qualified medical expense.  All other investment accounts are taxed at one of those three points.  With the high cost of health care and lengthening life expectancies in the U.S., it makes sense to save as much as possible into this supercharged tax-preferred account to pay for medical expenses in retirement.

Even if an account holder withdraws money for non-medical expenses, there is no penalty if the investor is over age 65 (20% penalty applies if younger than 65).  The distribution will incur regular income tax, but that is the same tax treatment as a traditional IRA that receives pre-tax funds at the time of contribution and is fully taxed as income upon withdrawal in retirement.  Thus, any money saved for the long-term into an HSA could be considered as additional IRA-type savings above the $6,000/$7,000 maximum.  Ideally, the full balance of the account is used tax-free on qualified expenses, but only owing income tax on non-qualified withdrawals in retirement after years of tax-deferred growth is not a bad backup option.

The breakdown between short-term and long-term savings within the account doesn’t have to be all or nothing as well.  If contributing $7,200 to a family HSA, an account holder could mentally earmark $2,800 (or whatever the health care plan’s annual deductible is) as being reimbursed from the account while paying any additional costs incurred out of regular cash flow and leaving the difference in the HSA to grow for retirement.

Final Thoughts

Most Americans keep small balances in their HSA accounts and only use each year’s contributions to pay for that year’s medical expenses.  According to the Employee Benefits Research Institute, only 14% of participants are contributing the maximum amount and only 5% of HSAs are invested in something other than cash.  This might be a necessity for many households, as annual health care costs can be expensive and all account contributions could be needed for that year’s costs.  However, if your income and cash flow situations allow you to pay your annual deductible and/or additional medical expenses out of pocket, contributing the maximum amount to an HSA and letting compound growth do its job could result in a large stockpile of assets to cover health care costs and more in retirement.

Reach out today. This could be the start of a great relationship.

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