When it comes to saving for retirement, it’s hard to beat the triple-tax-free retirement benefit provided by a Health Savings Account (HSA).
NOTE: This is an updated version of this blog: Health Savings Accounts: A Triple-Tax-Free Retirement Benefit – 2022 Update. This blog updates IRS limits for Health Savings Accounts and High-Deductible Health Plans. It also includes some edits and a new video. The section: Maximizing Health Savings Account Tax Benefits, if You Have Adult Children Under Age 26 is new for 2023.
The most common way to save for retirement through your employer is a workplace retirement account such as a 401(k) or a 403(b) plan. If you are self-employed, you can use a Keogh or a self-401(k) plan instead. However, these conventional ways to save may not represent the best choices. If you are employed and can realize similar rates of return, you may be better off contributing to a Health Savings Account (HSA) before funding conventional retirement accounts. (Note that depending on the actual circumstances, if you receive an employer match to your contributions, you should take advantage of that benefit first.)
In earlier posts where we shared some tax-planning tips (see here and here), we mentioned the benefits of contributing to an HSA. We wanted to expand on the benefits of including HSAs as part of your financial plan.
The tax rules drive this thought process. Contributions you make to your HSA are tax-deductible. You can withdraw money from your HSA tax-free if you use the money to pay for qualified medical expenses. Importantly, medical expenses for this purpose generally include qualified expenses incurred any time after the plan was established. While you can make tax-free contributions to 401(k) plans, you pay ordinary income tax rates on withdrawals. In other words, you save taxes three different times with an HSA. That means HSAs provide a triple-tax-free retirement benefit.
Some caveats
Of course, it may not work out quite as easily as described above. As Genie said in Aladdin, there may be a couple of quid pro quo or caveats.
- Depending on the available investment options and the associated fees, the expense-adjusted returns for an HSA might not be as high as they are for a 401(k) or 403(b) account.
- The number of investment options may also not be as varied in your HSA.
When you retire, you can withdraw money from your HSA to pay for qualified medical expenses. These withdrawals are tax-free. That means you don’t have to make a taxable withdrawal from your IRA or 401k. This can also help keep you from being bumped into a higher tax bracket.
Key Points:
- Health Savings Accounts Are Different Than Flex Spending Accounts.
- Health Savings Accounts Provide a Triple Tax-Free Retirement Benefit
- A family can contribute up to $7,750 annually to a Health Savings Account – more if you are at least one eligible individual is 55 or over.
- To get the optimal benefits from a Health Savings Account, you should invest the money for the future. You want to refrain from using it in the same year as you contribute money to the account.
What Is a Health Savings Account?
HSAs are tax-sheltered savings accounts available to those enrolled in high-deductible health plans (HDHP). We will explain more about what an HDHP is later. For now, understand that an HDHP charges lower premiums than traditional insurance plans. It also comes with higher deductibles and out-of-pocket maximums. An HSA provides tax benefits to help defray these higher costs.
Contributing to a Health Savings Account Can Make Sense
Many people overlook HSAs as retirement savings vehicles by using them to pay current medical bills. However, the accounts, which became effective as of January 1, 2004, come with more tax advantages than 401(k)s and individual retirement accounts. This applies if you use the funds to cover medical costs – whether now or in retirement. Even better, they can generate tax-free income.
Medical costs can represent a major retirement expense. According to the latest retiree health care cost estimate from Fidelity Benefits Consulting, a 65-year-old couple retiring in 2022 and expecting to reach their life expectancy, will need approximately $315,000 (in today’s dollars) to cover medical expenses throughout retirement. That estimate applies only to retirees with traditional Medicare insurance coverage. It does not include costs associated with nursing home care.
Health Savings Account: The Triple-Tax Retirement Benefit
Health Savings Accounts offer a triple-tax-free retirement benefit, making them one of the tax code’s most tax-favored savings vehicles:
- Assets contributed to an HSA can grow free of taxes.
- Savers can contribute to them on a pre-tax or tax-deductible basis.
- Account holders can withdraw the assets tax-free. This applies if the money goes toward (or is offset by) qualified medical expenses.
Given those tax benefits, some financial planners – including Apprise – argue that, if you have the financial wherewithal to do so, you should leave your HSA undisturbed. Instead, you should use after-tax, non-HSA dollars to cover healthcare costs as incurred. This strategy allows you to take full advantage of the tax-saving features of your HSA. You should spend less tax-efficient, taxable assets instead.
An Example of the Savings and Benefits Provided by Health Savings Accounts
Assume you are single, and your taxable income is $100,000. In 2023, your marginal federal income tax rate – the rate you pay on your last dollar of income – is 24%. If you live in Baltimore County, Maryland where Apprise Wealth Management is based, your marginal tax rate for state and local taxes is 7.95%. You will also pay FICA tax (which finances Social Security and Medicare) at a 7.65% rate. The result: you only get to keep about $0.61 of every dollar you earn.
If you put money in your HSA, you can shelter 100% of every dollar you save in your HSA forever if you use the money to reimburse qualified medical expenses.
Assume you save $3,000 in your HSA this year, and it grows at an annual inflation-adjusted rate of 4%. If that money stays in the account for 20 years, it will be worth $6,573. If you saved the same $3,000 in your 401(k), you would pay federal and state income taxes when you withdraw it in 20 years. Assuming the same federal and state rates as above), you would only have $3,987. Remember that this example only covers one year, too.
In other words, funds invested in an HSA can grow and produce higher returns than those available from other accounts. Why? You don’t pay any taxes on the amount you put into your HSA. No taxes are due on the earnings realized from any deposits into your HSA. Plus, you don’t owe any taxes when you withdraw the funds, as long as you use them to pay for qualified medical expenses. That’s three times you could pay taxes on the money you deposit in your HSA. But you don’t pay taxes any of those times. You get a triple-tax-free retirement benefit.
Even if you decide to use the HSA to pay current medical bills, it still makes sense to contribute. Why? The upfront tax deduction (roughly 39%) allows you to keep the money you would have otherwise had to pay in taxes.
What is a High-Deductible Health Care Plan?
In 2023, a high-deductible health care plan (HDHP) has a minimum annual deductible of $1,500 for individuals and $3,000 for families. The plan must have annual out-of-pocket expenses (deductibles, copayments, coinsurance, and other amounts but not premiums) totaling less than $7,500 for individuals and $15,000 for families. Note that this limit does not apply to deductibles and expenses for out-of-network services if the plan uses a network of providers. Only deductibles and out-of-pocket expenses for services within the network count when considering whether the limit applies.
How Much Can I Contribute to My Health Savings Account?
In 2023, individuals in high-deductible healthcare plans can save up to $3,850 in their HSAs. Those with family plans can save up to $7,750. You can contribute up to the limit regardless of your income. Your entire contribution is tax-deductible. You can contribute even when you have no income. Self-employed individuals can also contribute.
If you have an HSA and you’re 55 or older, you can make an extra “catch-up” contribution of $1,000 per year. A spouse who is 55 or older can do the same, provided each of you has his or her own HSA account. Please note this important distinction. If you or your spouse have family healthcare benefits and you are both 55 or over, the policyholder can only contribute $8,750 this year – the $7,750 family contribution plus $1,000 for being 55 or over. If you are also 55 or older and want to maximize your total contribution for the year, you must have a separate account in your name and contribute $1,000 to that account.
Remember that if you and your spouse are both 55 or older, you must both have your own HSA to claim the full triple-tax-free retirement benefit of $9,750 in 2023.
Unlike the use-it or lose-it rules that apply to flexible spending accounts, contributions to HSAs can roll over to the following year.
Please note: Account holders who exceed the contribution limit are subject to an annual 6% excise penalty tax on excess contributions unless they are withdrawn from the HSA before that year’s tax deadline.
How Can You Use the Amounts in Your Health Savings Account?
- You can withdraw money from the account to cover ongoing health expenses.
- You can allow the amount in your HSA to grow over time by paying for ongoing health expenses with non-HSA funds.
Treating your HSA as an investment account instead of a short-term expense account allows you to invest the funds. They can then grow into another source of retirement funds or to cover medium- to long-term health care expenses. This approach also provides the greatest growth potential. That is why, to the extent possible, you should try and avoid spending these funds now. If you have an emergency or other very large medical expense, you can use your HSA funds, if necessary.
Moving Balances from your HSA
HSA assets are portable – savers can take the money with them when they change jobs. Investors can also move the money to a different custodian and allow their financial advisor to have oversight of the account. There are three ways to transfer assets into an HSA:
- You can move the funds via a trustee-to-trustee transfer, in which one custodian wires the assets to another. Savers are allowed an unlimited number of these transactions; they are not rollovers.
- Account holders may receive a rollover check from their custodian and deposit the money into a new HSA within 60 days. You can only complete this type of transaction once a year.
- Investors may make a once-in-a-lifetime transfer of savings from an individual retirement account into an HSA. The amount transferred cannot exceed that year’s contributions limits as described above. (For example, if you are over 55 and covered by a family healthcare plan, you could transfer $8,750 in 2023.) This transfer is also referred to as a Qualified HSA Funding Distribution (QHFD) from an IRA. Note that these rules do not apply to ongoing SIMPLE or SEP IRAs. After a QFHD, an individual must remain HSA eligible for a one-year testing period to avoid taxes and penalties.
The Ability to Pay for Almost Anything Tax-Free from your HSA
If you keep good records, you can use your HSA to pay for almost anything tax-free throughout your lifetime. If you keep your medical expense receipts, you can withdraw funds from your HSA to cover prior medical expenses in a future year.
You want to be careful about double-dipping. An expense can only be claimed once.
You do not need to have current medical expenses; you merely need to have a receipt from any time in the past to get reimbursed. Qualified medical expenses can arise from any year (starting with the year the HSA is opened– not just the current one. This proactive strategy allows an HSA holder to supplement retirement income tax-free. It can also reduce your withdrawals from a taxable 401(k) plan account. This could also help keep tax rates lower, as additional taxable withdrawals from a 401(k) account can bump the holder into a higher tax bracket. It may also help you limit your Medicare premiums.
Contributions to your Health Savings Account Can Be Made After Year-End
There are other ways in which HSAs provide flexibility. Like with an IRA, taxpayers have until April 15th – April 18th in 2023 – to make contributions for the previous tax year. For example, assume a married 58-year-old self-employed worker who participated in a family HDHP had $5,000 in medical expenses and wanted to pay for them with after-tax, out-of-pocket money. After meeting with her financial advisor, she learned of her eligibility to contribute to an HSA.
As a result, before filing her tax return in April, she can establish an HSA and contribute $5,000. This would lower her federal and state income tax bills. She could even withdraw the $5,000 from her HSA and reimburse herself.
This approach is not as beneficial to a long-term financial plan as leaving the money in the account. But it still provides benefits.
Note that making a prior year contribution requires you to take a simple, but special, action with your HSA custodian. When you make the contribution, you must indicate specifically that it applies to the prior tax year. Why? A contribution made in say, January, can be applied to either the current year or the prior year. When you make the contribution, there should be an indicator to your custodian of the tax year to which it applies. Make sure you select the correct one.
Maximizing HSA Tax Benefits, if You Have Adult Children Under Age 26
The IRS imposes specific requirements related to who can contribute to an HSA. First, the individual must be covered by a HDHP and have no other coverage or be enrolled in Medicare. Second, nobody else can claim the individual as a dependent on their tax return. This allows for an unusual twist. The account owner does not need to be covered under their own healthcare plan. This means a young adult who is covered under their parents’ HDHP plan (and who cannot be claimed as a dependent on their parents’ tax return) could potentially be eligible to contribute to their own HSA. It gets even better though. While spouses can only make combined contributions up to the family maximum contribution limit ($7,750 in 2023), non-spouses covered under the same health plan can contribute to their own HSA. That’s not all. They can contribute up to the family limit as well.
Remember that you can often cover your child under your healthcare plan through the age of 25. The additional cost may not be significant either. Consider this: If you cover your child under your healthcare plan, they can still contribute the family maximum to their own HSA.
Please note that I have seen this used in other ways as well. I have an unmarried female client involved in a committed relationship. His old healthcare plan allowed him to cover her as well under a family plan. She was also allowed to contribute up to the family maximum amount to her own HSA. He has since changed jobs, and his new employer no longer allows him to cover my client under his healthcare plan. Thus, she can only contribute $3,850 in 2023 to her HSA.
Other Advantages of Health Savings Accounts
Family Coverage:
HSA holders can use assets from their HSAs to pay for qualified medical expenses incurred by their spouses as well as dependents even if they are not eligible to establish their own HSAs or even if their insurance coverage is different than that of the HSA holder.
Flexibility:
HSA holders can withdraw HSA assets or change them at any time regardless of their current employer or current eligibility. In addition, there are no required minimum distribution rules or requirements. That means you do not have to start taking withdrawals at a certain age or withdraw a certain amount.
Full Vesting:
Whether made by the employee or an employer, contributions to an employee’s HSA vest immediately to the employee.
Long-Term Care Insurance:
You can also use HSA distributions to pay for Long-Term Care Insurance tax- and penalty-free (however the amount is limited, see IRC 213(d)(10)).
Medicare/Retirement:
The Medicare Part B monthly premium (for doctor visits) gets deducted directly from a recipient’s monthly Social Security check. HSA holders can get reimbursed for those costs from HSA assets as well as Part D monthly premiums (for drug prescriptions).
No Use-It-Or-Lose-It-Rule:
Unlike amounts withheld for your flexible spending account, you need not spend amounts contributed to an HSA. Unused HSA funds continue to belong to the owner.
Portability:
A worker can open an HSA anywhere she wants. For example, oftentimes the fees associated with employer-sponsored HSA are too high, and/or the investment options are not desirable. You can withdraw assets from the HSA and invest them elsewhere into a more desirable HSA. You must complete this process within 60 days. It may involve less hassle than a rollover.
Sources of Contributions:
The HSA owner, a family member, or an employer can make contributions.
Treatment at Death:
When an account holder dies, you can roll over the HSA can to a spouse tax-free. That spouse can also continue to save and invest in the HSA. However, if you roll the HSA over to a non-spouse, the account’s balance is fully taxable (like what happens with a retirement plan account). As a result, HSA assets should not be held for the long term after the first spouse dies or if both spouses are in poor health.
You Must Keep Track of Out-of-Pocket Healthcare Costs
You should strive to maximize the balance of your HSA and leave more money in the account for retirement. To do so, you must establish a system to keep track of the out-of-pocket money you spend on current medical expenses. Saving receipts allows you to file for reimbursement from your HSA at any time. Following this process helps you generate tax-free retirement income.
The old-fashioned way to do this would be to store your receipts in a shoebox or a file cabinet. If you have a scanner (you can also install a scanning app on your phone or tablet), you can use it to save receipts. Check with your HSA provider as well. Many providers offer electronic repositories for such receipts.
In general, your records must be sufficient to show that:
- You used the distributions exclusively to pay or reimburse qualified medical expenses;
- The qualified medical expenses had not been previously paid or reimbursed from another source; and
- You did not claim the medical expenses as an itemized deduction in any year.
You do not have to send these records with your tax return. Keep them with your tax records.
It is also important to make sure your heirs know where you keep the information. When spouses are named as beneficiaries, they can inherit HSAs tax-free. Other beneficiaries may have to pay income tax on the balance they receive following the account owner’s death. Importantly, you can tap the account tax-free to pay the account owner’s unreimbursed qualified medical expenses within a year of death as well.
How Do You Report Your Health Savings Account Activity to the IRS?
You must file Form 8889 with your tax return if you (or your spouse, if married filing a joint return) had any activity in your HSA during the year. You must file the form even if only your employer or your spouse’s employer made contributions to the HSA.
If during the tax year, you are the beneficiary of two or more HSAs or you are a beneficiary of an HSA and you have your own HSA, you must complete a separate Form 8889 for each HSA. You must also complete a controlling Form 8889 combining the amounts shown on each separate Form 8889. Attach the separate Forms 8889 to your tax return after the controlling Form 8889.
Investing Your HSA for Retirement
If your intent is to save your HSA for retirement, you can invest it in a diversified portfolio the same as other retirement plan accounts. If you leave your contributions in a low-risk option like a money-market fund, the account’s growth will likely be minimal. Doing so will mitigate one of the HSA account’s biggest advantages – the ability to grow tax-free.
Unhappy with your investment options? You can transfer your HSA to another financial institution that offers such accounts. You might also want to move your account to avoid high fees. For example, according to a recent Morningstar report, that compares options from 10 large HSA providers, the three most important criteria to consider are maintenance fees, interest rates offered, and additional fees. If you would like other options, check out HSAsearch.com. That database evaluates 759 different providers.
Unfortunately, few HSA participants invest assets held in their HSA accounts. The majority either save their HSA assets in a savings account or use their HSA on an ongoing basis to cover healthcare costs. Very few participants contribute the maximum allowable amount to their HSAs as well.
Are There Any Drawbacks or Limitations to Using Health Savings Accounts
There must be a downside to contributing to an HSA, especially because it relates to taxes. Here are some things to remember:
Limitations on Withdrawals.
To withdraw money tax-free, you must use it for qualified medical expenses. These can include medical costs as well as dental- and vision care expenses, premiums for all types of Medicare plans except for Medigap, and a portion of long-term insurance care premiums.
Use for Nonmedical Expenses.
If you use your HSA for nonmedical expenses, you will owe income tax on the distributions – plus a 20% penalty if you are younger than 65. (Note that the penalty for early withdrawals from an IRA is only 10%.)
You Must Maintain Records/Receipts.
Whether you keep them in paper or electronic form, you need to have support for any reimbursed expenses. But, if you do, and you have been contributing for a long time, you can use the money for almost anything. You could buy a boat, go on a special vacation, or do anything else you want to enjoy during your retirement years.
Medicare Ineligible.
Beginning with the first month you enroll in Medicare, your contribution limit is zero. If you delay Medicare enrollment, make sure to stop contributing to your HSA at least six months before you do plan to enroll in Medicare. If you do not follow this rule, you may incur a tax penalty.
When You Retire, You May Want to Spend Your HSA Funds Sooner Rather Than Later.
You can pass your HSA to your spouse if you die. He or she can then use it for qualified medical expenses. For non-spouse survivors, the account loses its HSA status, and its fair market value becomes taxable to the beneficiary. However, the beneficiary can use the HSA funds to pay for the account holder’s medical expenses for up to 12 months after their death.
If your HSA is transferred to someone other than your spouse at death, the value of account assets left in your HSA as of your death will be includible in your beneficiary’s gross income in the year that you died. Note that a non-spouse beneficiary (other than the deceased account holder’s estate) may lower the includible amount by the amount of any payments made from the HSA for qualified medical expenses incurred by you before you die. This only applies to payments made within one year of death.
Tax Treatment of Health Savings Accounts May Vary by State
The strategies described in this article are based on federal tax law. Most states follow federal tax law when it comes to HSAs, but yours may not. At the time of writing, California, and New Jersey tax HSA contributions. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming don’t have state taxes, so the state tax benefit is not applicable. New Hampshire and Tennessee tax HSA earnings if you make a taxable withdrawal from your account. Even if you live in a state that taxes HSAs, you still qualify for federal tax benefits.
Can I Use My HSA to Fund Insurance Premiums?
With some exceptions, insurance premiums related to the following types of insurance or events may be considered qualified medical expenses:
- Long-term care insurance: However, such amounts are subject to limits based on age and are adjusted annually.
- COBRA: Healthcare continuation coverage (such as coverage under COBRA).
- Unemployment: Healthcare coverage paid while you are receiving unemployment compensation under federal or state law.
- Medicare: If you are 65 or older, the cost of Medicare and other health care coverage (other than premiums for a Medicare supplemental policy, such as Medigap).
Many of the rules surrounding an HSA or a QHFD are complex, so we recommend consulting with a professional before acting and again when filing your return. If you want to do more research, you can review IRS Publication 969.
Concluding Thoughts
If you have a high deductible health care plan, you should open an HSA. HSAs can play an important role in your financial plan and improve your retirement readiness. Since they are triple tax-free, HSAs can provide greater tax benefits than other retirement savings vehicles.
If you have any questions about HSAs or believe something was not addressed by the above, please schedule a free call or virtual meeting via Zoom by clicking this link. You can also complete our contact form, and we will be in touch.
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.
