Please note: This blog was updated in June 2021 and July 2022. The most up-to-date blog can be found here.
When we think about saving for retirement or creating a financial plan, the first thing that usually comes to mind is contributing to a workplace retirement account such as a 401(k) or a 403(b) plan. If we are self-employed, our thoughts typically turn to a Keogh plan, which is roughly the equivalent of a 401(k). However, conventional wisdom may not always rule the day. If you are employed and able to realize similar rates of return, you may be better maximizing contributions to a Health Savings Account (HSA) before funding your retirement plan account. (Note that depending on the actual circumstances, if your employer provides some sort of match to your contributions, you may want to take advantage of that benefit first.)
In an earlier post about tax-planning opportunities, we mentioned the benefits of contributing to your HSA. We thought it would be worth expanding on the benefits of including HSAs as part of your financial plan.
The tax rules drive this thought process. Contributions made to HSAs not made by your employer are tax-deductible. Withdrawals from HSAs are tax-free if they are used 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 contributions to 401(k) plans are tax-free, withdrawals are taxed at ordinary income tax rates.
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.
Once you reach retirement, HSA withdrawals can be used to pay for qualified medical expenses. Since such withdrawals are tax-free, they can reduce the amount that would otherwise be withdrawn from a workplace retirement account or a traditional IRA. This could provide a further benefit in helping to keep a retiree from being bumped into a higher tax bracket.
What Is an HSA Anyway?
HSAs are tax-sheltered savings accounts available to those enrolled in a high-deductible health plan (HDHP). While we will explain more about what an HDHPis later, in general, an HDHP charges lower premiums than traditional insurance plans, but comes with higher deductibles and out-of-pocket maximums. An HSA provides tax benefits to help defray these higher costs.
Contributing to an HSA Can Make Sense
Many people overlook HSAs as retirement savings vehicles because they use them to pay current medical bills. However, the accounts, which have been in existence since 2003 (they became effective as of January 1, 2004), come with more tax advantages than 401(k)s and individual retirement accounts when used to cover medical costs – whether now or in retirement. Even better, they can create tax-free income in retirement.
Medical costs can represent a major retirement expense. According to the latest retiree health care cost estimate from Fidelity Benefits Consulting (in 2017), a 65-year-old couple retiring this year and expecting to reach their life expectancy will need an average of $275,000 (in today’s dollars) to cover medical expenses throughout retirement, up from $260,000 in 2016. That estimate applies only to retirees with traditional Medicare insurance coverage. It does not include costs associated with nursing home care.
The Triple-Tax Benefit
HSAs offer a triple-tax benefit, making it one of the tax code’s most tax-favored savings vehicles:
1. Assets contributed to HSAs grow free of taxes.
2. Savers can contribute to them on a pre-tax or tax-deductible basis.
3. Account holders can withdraw the assets free of taxes, provided the money goes toward (or is offset by) qualified medical expenses.
Given those tax benefits, some financial planners argue that individuals who have the financial wherewithal to do so should leave their HSAs undisturbed, using after-tax, non-HSA dollars to cover healthcare costs as they occur. That strategy allows the investor to take maximum advantage of the tax-saving features of the HSA, while spending the less-tax-efficient taxable assets.
An Example of the Savings and Benefits
Assume your annual salary is $90,000. In 2018, your marginal federal income tax rate is 24%. If you live in Baltimore County, Maryland where Apprise Wealth Management is based, you will also pay state and local taxes at a 7.58% rate. You will also pay FICA tax (which finances Social Security and Medicare) at 7.65%. 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 that you save $3,000 in your HSA this year and that it grows at an annual inflation-adjusted rate of 4%. If the money stays in the account for 20 years, it will be worth $43,822.46. On the other hand, if you saved that same $3,000 in your 401(k) and paid federal and state income taxes on its withdrawal in 20 years (using the same federal and state rates as above), you would only have $29,983.33. Remember that this example only covers one year, too.
In other words, the returns you get from an HSA can grow to produce higher returns than those available from other accounts.
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?
A high-deductible health care plan (HDHP) has a minimum annual deductible of $1,350 for individuals and $2,700 for families. The plan must also have annual out-of-pocket expenses (deductibles, copayments, coinsurance, and other amounts but not premiums) that do not exceed $6,650 for individuals and $13,300 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. Instead, only deductibles and out-of-pocket expenses for services within the network should be used to figure whether the limit applies.
How Much Can I Contribute?
In 2018, individuals in high-deductible health care plans can save up to $3,450 in their HSAs if they have single coverage. Those with family plans can save up to $6,900. You can contribute up to the maximum regardless of your income, and your entire contribution is tax-deductible. You can even contribute in years when you have no income. You can also contribute if you’re self-employed.
If you have an HSA and you’re 55 or older, you can make an extra “catch-up” contribution of $1,000 per year, and a spouse who is 55 or older can do the same, provided each of you has his or her own HSA account.
Unlike the use it or lose it rules that apply to amounts contributed to flexible spending accounts, amounts contributed to HSAs can roll over to the following year.
How Can You Use the Amounts in Your HSA?
1. The money can be withdrawn from the account to cover ongoing health expenses.
2. Ongoing health expenses can be covered out of pocket and the amount in the HSA can accumulate over time.
By treating your HSA like an investment account instead of a short-term expense account, the funds can be invested and grow into another source of retirement funds or be used 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 unless, of course, you have an emergency or other very large medical expense.
Moving the Money
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 so that their financial advisor has oversight of the account. There are three ways to transfer assets into an HSA:
1. Funds can be moved 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.
2. Account holders may receive a rollover check from their custodian and deposit the money into a new HSA within 60 days. Such transactions are permitted once a year.
3. Investors are permitted 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, you could transfer $7,900 in 2018.) This transfer is also referred to as a Qualified HSA Funding Distribution (QHFD) from an IRA. It should be noted 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
If you keep good records, you can use your HSA to pay for almost anything tax-free. Assume that you make regular contributions to your HSA and pay for qualified medical expenses out-of-pocket without using the funds in your HSA during your career. If you keep your medical expense receipts, you can subsequently be reimbursed for those expenses from your HSA.
There is not a need to have current medical expenses; you merely need to have a receipt from any time in the past to get reimbursed. This means 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 rather than withdrawing money 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 as well as possibly increase Medicare premiums.
Contributions Can Be Made After Year End
There are other ways in which HSAs provide flexibility. Just like with an IRA, taxpayers have until April 15th to make contributions for the previous tax year. For example, assume a married 58-year old self-employed worker had $5,000 in medical expenses that she paid for 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 established an HSA and contributed $5,000. This would lower her federal and state income tax bill. The worker could then withdraw the $5,000 from her HSA and reimburse herself.
As a result, she would save a lot in taxes. While this set of circumstances is not as beneficial to your long-term financial plan as leaving the money in the account would be, it is still worthwhile.
Note that making a prior year contribution requires a simple but special action be taken with your HSA custodian. When you make the contribution, you will have to indicate specifically that it is going towards the prior tax year. This is because a contribution made in say, January, can be used for either the current year or prior year. When you make the contribution, there should be an indicator to your custodian for the tax year to which it applies, so make sure you pick the correct one.
Other Advantages of HSAs
· Family Coverage: HSA holders can use assets from their own 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 to begin to begin taking withdrawals at a certain age or withdraw a certain amount.
· Full Vesting: Whether they are made by the employee or an employer, contributions to an employee’s HSA are immediately vested in the employee.
· Long-Term Care Insurance: HSA distributions can even be used 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) is deducted directly from a recipient’s monthly Social Security check. The HSA holder 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, amounts contributed to an HSA do not have to be spent. Unused HSA funds continue to belong to the owner.
· Portability: An HSA can be opened anywhere a worker wants. For example, oftentimes the fees associated with your employer-sponsored HSA are too high, and/or the investment options are not desirable. You can withdraw the assets from the HSA and invest them elsewhere into a more desirable HSA (within 60 days, but without the hassle that comes with a rollover).
· Sources of Contributions: In addition to the HSA’s holder, a family member and an employer can also contribute.
· Treatment at Death: When an account holder dies, the HSA can be rolled over to a spouse tax-free. That spouse can also continue to save and invest in the HSA. However, if the HSA is rolled over to a non-spouse, the account’s balance is fully taxable (like what happens with a retirement plan account).
You Must Keep Track of Out-of-Pocket Health Care Costs
If your goal is to maximize the balance of your HSA so there is more money left in the account for retirement, you must establish a system to keep track of the out-of-pocket money you spend for current medical expenses. Saving your receipts will allow you to file for reimbursement from your HSA at any time and create tax-free retirement income.
The old-fashioned way to do this would be to store your receipts in a shoebox or 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 offer electronic repositories for such receipts.
In general, your records must be sufficient to show that:
· The distributions were used exclusively to pay or reimburse qualified medical expenses;
· The qualified medical expenses had not been previously paid or reimbursed from another source; and
· The medical expenses were not claimed 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. Spouses, who are named as beneficiaries, 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, the account can be tapped tax-free to pay the account owner’s unreimbursed qualified medical expenses within a year of death as well.
How Do You Report Your HSA 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 of the statement Forms 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, it can be invested 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, which 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, monthly maintenance fees can be as high as $4.50 a month. If you want to see what other options are available, you can go to HSAsearch.com, a database from Devenir Group LLC. This post surveys several investment options and suggests which one might be the best overall.
Few HSA participants invest the assets held in their HSA accounts, however. The majority, by contrast, either saved their HSA assets in the savings-account option or spent the HSA money 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?
There must be a downside to contributing to an HSA, especially because it relates to taxes. Here are some things to keep in mind:
· Limitations on Withdrawals. To withdraw money tax-free, it must be used 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 the 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 anything else you want to enjoy during your retirement years.
· Medicare Ineligible. Beginning with the first month you are enrolled in Medicare, your contribution limit is zero.
Tax Treatment 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, Alabama, California, and New Jersey tax HSA contributions, and New Hampshire and Tennessee tax HSA earnings. Even if you live in a state that taxes HSAs, however, you still qualify for federal tax benefits.
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 would recommend consulting with us as well as your tax professional before acting and again when filing your return. If you want to do more research you can consult IRS.gov and Publication 969.
Deciding whether or not to open an HSA can be an important part of your financial plan and preparing for your financial future. If you would like to discuss issues such as this with us, please 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.