If you have a health savings account (HSA), you know that it’s advertised purpose is to pay for out-of-pocket medical costs. However, it may surprise you to learn that this account can function as an excellent retirement savings vehicle, too.
First, what is a Health Savings Account (HSA)? HSAs are accounts available to those with high-deductible health insurance plans (HDHP) from their employers for the payment of out-of-pocket medical expenses. These accounts allow employees to set aside pre-tax dollars throughout the year and use these funds to pay for qualified medical expenses at their discretion. In contrast to Flexible Spending Accounts (FSAs), these contributions do not expire at year’s end. Instead, they can remain in the account, be invested for any time horizon and used at the account holder’s discretion.
The Triple Tax Advantage of an HSA
- Your contributions to an HSA can be made via payroll deductions, as well as from your own funds. Both are tax-deductible, even if you don’t itemize. If they’re made from your own funds, they’re considered to be made on a pre-tax basis, meaning that they reduce your federal and state income tax liability—and they’re not subject to FICA taxes, either.
- Your account balance grows tax-free. Any interest, dividends, or capital gains you earn are nontaxable.
- Withdrawals for qualified medical expenses are tax-free. This characteristic is what truly sets an HSA apart from traditional retirement accounts (401ks and IRAs). Withdrawals from traditional retirement accounts are taxed at ordinary income rates, no matter your age or the use of funds.
Don’t Spend Your Contributions
With such attractive tax treatment an argument can be made that the best way to use an HSA is to treat it as an investment tool that will improve your financial picture in retirement rather an immediate expense account. And the best way to do that is to avoid spending your HSA contributions until retirement. Cash flow permitting, you should pay cash out of pocket for your medical bills and allow your HSA contributions to grow tax-advantaged for later use.
In other words, think of your HSA contributions the same way you think of your contributions to any other retirement account: untouchable until you retire. As if HSA accounts were not already attractive enough, the IRS also does not require you to take distributions from your HSA in any year, before or during retirement. In other words, there are no Required Minimum Distributions (RMDs) – even at age 72 and beyond.
If you absolutely must spend some of your contributions before retirement, be sure to spend them on qualified medical expenses. These distributions are not taxable. If you are forced to spend the money on anything else before age 65, you will pay a 20% penalty and income tax on those distributions.
However, after age 65, HSA funds withdrawn for non-qualifed expenses are no longer subject to penalty – just income tax. Essentially these withdrawals are treated just like normal IRA distributions. With this in mind, you don’t have to worry about over-saving in your HSA because it doesn’t all need to be spent on healthcare expenses.
By waiting as long as possible to spend your HSA assets, you maximize your potential investment returns and give yourself as much money as possible for the future.
Health Care Is Only Getting More Expensive – Take Every Advantage You Can Get
According to research conducted by Fidelity Investments an average couple retiring at age 65 is likely to need $300,000 in after-tax dollars to pay for healthcare expenses over the remainder of their lives. * Furthermore, cost increases in healthcare have historically outpaced inflation by a substantial margin. In other words, if you are not fortunate enough to have a generous retiree health insurance plan from your employer, healthcare is likely to be one of your largest recurring expenses in retirement. HSA accounts are perhaps the most efficient investment vehicle for addressing such expenses, so if you have the ability to contribute to one, USE IT!
