We often hear about the 401(k) plan as the primary way to save for retirement, but is there another tool we’re overlooking?
Health savings accounts (HSAs) are often considered as a means to fund current medical expenses, but they’re also gaining recognition as a tool to save additional funds for retirement, specifically medical costs — one of the largest expenses retirees must plan for.
According to the latest retiree health care cost estimate from Fidelity Benefits Consulting, a 65-year-old couple retiring in 2017 with Medicare insurance coverage will need an average of $275,000 (in today’s dollars) to cover medical expenses throughout retirement, not including costs associated with nursing home care.1 This is a $15,000 increase from $260,000 in 2016!2
Health care costs are even more significant for retirees with higher incomes. According to Barron’s, a healthy 65-year-old couple with an annual income between $214,000 and $267,000 — which places them in the middle of Medicare’s high-income tier — will face average health care costs of $565,142 in today’s dollars for coverage throughout retirement.3 This includes Medicare premiums and surcharges, Medicare supplemental coverage and dental and vision care.
Retirees who have failed to plan for these health care expenses are likely to be unprepared; but those who plan ahead and start taking advantage of HSAs early in their lives are in a better position to tackle these substantial future costs.
How do HSAs work?
HSAs are custodial accounts that allow individuals currently covered under high-deductible health plans (HDHPs) to set aside funds to pay for qualified medical expenses. Similar to IRA contributions, contributions to an HSA made with after-tax dollars are “above-the-line” deductions, meaning they are deductible in the calculation of adjusted gross income (AGI). Pretax contributions to an HSA made via payroll deduction reduce the dollars you are taxed on, and therefore, your total tax. Any withdrawals you take from HSAs to pay for qualified medical expenses are completely tax-free.
For an individual health plan to be considered an HDHP for 2018, it must have an annual deductible of at least $1,350 and annual out-of-pocket expenses (including the deductible) of no more than $6,650. For a family health plan to be considered an HDHP for 2018, it must have an annual deductible of at least $2,700 and annual out-of-pocket expenses (including the deductible) of no more than $13,300. Those who have health coverage that meets the above requirements are eligible to contribute to an HSA.
In 2018, individuals with self-only insurance coverage under an HDHP can contribute a maximum of $3,450 to their HSAs; those with family coverage under an HDHP can contribute a maximum of $6,850. Individuals age 55 or older can contribute an additional $1,000 annually to an HSA as a catch-up contribution.
HSA accounts are not tied to employers and the balance can be rolled over into another account or linked via payroll deduction to a new employer. Most importantly, contributions you don’t spend each year on qualified medical expenses will carry over indefinitely to future years, making the HSA a valuable tool for accumulating savings for long-term expenses.
What expenses can be paid from an HSA?
Qualified medical expenses can be paid from an HSA, and any and all withdrawals for these expenses will be income tax-free.
IRS Publication 502 includes a list of qualified medical expenses that can be paid from HSAs. One important caveat to note is that when adding up medical expenses paid during the year for the purpose of claiming an itemized deduction, you cannot include any expenses paid out of an HSA in total medical expenses.
Retirees can benefit tremendously from having funds in their HSAs available to use for their health care expenses. Those over age 65 can use HSA funds to pay for Medicare Parts A, B and D (but not Medicare supplemental plans), and any deductibles, coinsurance and copayments. Certain services applicable to many retirees — including dentures, the majority of dental care, hearing aids and eye examinations — are not covered by Medicare Parts A and B, so an HSA can benefit retirees who incur these costly, out-of-pocket health care expenses.4 Furthermore, long-term care costs — and tax-qualified long-term care insurance premiums — can be paid from an HSA, which means the tool can also be a valuable way to help retirees cover some or all long-term care needs.
Those over age 65 are eligible for a different benefit — they can access HSA funds for any purpose without being subject to the 20% penalty charged to younger individuals who make nonqualified withdrawals. However, keep in mind that withdrawals for a purpose other than qualified medical expenses are taxed.
How tax-efficient are HSAs?
A valuable piece of retirement savings and tax planning advice is for employees to strive to contribute the maximum to their traditional, employer-sponsored 401(k) plans. This serves two purposes: it reduces taxable income and allows employees to accumulate retirement savings. While traditional 401(k) contributions reduce taxable income — and therefore, current taxes owed — any withdrawals in retirement are taxed at ordinary income tax rates, which can have tax implications for those with large balances in these plans.
If your 401(k) plan offers a Roth feature, you can take advantage of tax-free withdrawals in retirement, but contributions made to the plan do not reduce your taxable income; therefore, you pay tax now. With both traditional and Roth 401(k) plans, you pay tax once, either on your contributions to the plan or on your withdrawals from the plan — but not both.
In contrast to 401(k) plans, HSAs are “double” tax-free. What does that mean? If contributions and withdrawals are managed properly, HSAs are never taxed. HSA contributions up to the maximum (and that are made with after-tax dollars) are an above-the-line income tax deduction; if the contributions are made with pretax dollars, they reduce taxable income. When used to pay for qualified medical expenses, distributions are tax-free; any interest and investment earnings are also tax-free.
When looking at the tax advantages, HSAs can be a beneficial vehicle to fund retirement expenses, especially when used in conjunction with other savings vehicles such as 401(k) plans.
Using an HSA as a savings and investment vehicle
Anyone covered by an HDHP should consider taking advantage of the double tax-free benefit HSAs provide. While the amount you can and should contribute depends on many factors — including what you can afford to contribute, your health history, any upcoming health events and your risk tolerance — there are some guidelines you should keep in mind.
Those just starting to make contributions to HSAs should consider contributing enough to cover their typical, out-of-pocket qualified medical expenses for the year — which, depending on their health situation, may be the entire amount of the annual deductible. More established savers and the risk-averse preparing for a worst-case scenario should strive to accumulate a balance that covers the annual deductible and an additional amount to cover the rest of their plan’s annual out-of-pocket maximum. If you have funds available in your HSA, you will be better prepared financially for an unexpected trip to the emergency room.
High-income earners who are already contributing the maximum to their 401(k) and are looking for an additional retirement savings vehicle should also consider contributing the maximum to their HSA, which will provide an additional retirement funding source.
Like any other investment or retirement account, it is important to invest a portion of the contributions to take full advantage of the growth potential of the funds in the years until retirement — but you should avoid investing everything. You cannot predict if and when you may experience a medical event and need access to your funds; therefore, it is a best practice to leave a few years’ worth of future expenses in cash where these funds will remain safe from potential market volatility.
If you accumulate a significant amount in your HSA, many providers offer the ability to invest in mutual funds. Before you invest, consider the mutual fund options available and the costs of these mutual funds. You should also enlist the help of a qualified, credentialed advisor when deciding whether that particular strategy is right for you.
Is the HSA right for you?
As HDHPs increase in popularity, it is important for individuals covered under them to evaluate whether to use an HSA in their overall financial plan. There’s no denying that the cost of health care is increasing dramatically — even today, Americans pay $3.4 trillion a year for care expenses.5 By taking advantage of tax-efficient savings vehicles, including the HSA, you can ease the burden of future health care costs and put the extra funds to work for your retirement goals.