Imagine a savings account where your deposits are tax-deductible, your dollars grow tax-free, and they can be withdrawn tax-free. Many investors are surprised when we tell them that such a vehicle already exists: It’s a Health Savings Account (HSA).
Given its tax-favored status, the HSA doesn’t get nearly the attention it deserves. But earlier this year The Wall Street Journal published a good article on the subject: “HSAs Offer Tax Benefits Beyond 401(k)s.” The article describes a notion we’ve been advancing ourselves: HSAs can be used not only for their primary purpose, but as an integral part of your greater retirement and tax planning efforts. That’s why we think most people should take advantage of available HSAs, while also saving significant amounts in their 401(k)s, IRAs or similar retirement-saving vehicles.
The HSA’s Triple-Play Advantages
The HSA’s primary purpose is to help you save for current and future medical expenses.
Established in 2003 as part of the Medicare Prescription Drug, Improvement, and Modernization Act, the HSA’s primary purpose is to help you save for current and future medical expenses. As health insurance gets more expensive, most of us are experiencing higher deductibles and higher out-of-pocket costs. To encourage us to save for these costs, Congress set up the HSA with a triple-play of incentives:
- Contributions are deductible on your tax return.
- Investments made inside your HSA grow tax-free, just as in an IRA or 401(k).
- Before and after retirement, you can pay for qualified medical expenses with tax-free withdrawals from your HSA.
HSA “Rules of Engagement”
Of course there are the usual details to consider when determining how an HSA might fit into your own financial plans. We are happy to discuss these with you personally, but here are some highlights.
- Contribution Requirements. To contribute to an HSA, you must have an HSA-qualified, high-deductible health insurance policy. The deductible must be at least $2,600 per year for a family ($1,300 for an individual). You can contribute to an HSA whether or not you are working, and there is no income limit. If you are on Medicare, you are not eligible to contribute to an HSA – although you can pay Medicare and most Long-Term Care insurance premiums from an existing HSA account.
- Contribution Limits. You can contribute up to $6,750 each year for a family ($3,350 for an individual). If you are over age 55 then you can contribute an additional $1,000 per year.
- Contribution Deductions. If you have not yet filed your 2015 tax return, you have until April 18, 2016 to make a contribution and receive a 2015 deduction.
- Spending Flexibility. HSAs are not a “use it or lose it” deal; you do not have to spend the entire balance or any amount each year. Like an IRA or 401(k), your balance is available forever, until you’ve spent it all. Unlike your IRA or 401(k), there are no required minimum distributions at 70 1/2.
- Spending Parameters. If you withdraw HSA dollars before age 65 and you do NOT use them for qualified medical expenses, they are subject to ordinary income tax plus a 20% penalty. After age 65, withdrawals not used for medical care are subject to ordinary income tax, but no penalty.
Your HSA and Your Optimal Retirement
Beyond accumulating tax-favored savings for meeting your medical costs, the HSA can also serve as a valuable addition to your retirement planning. Especially if you can fund your HSA to the max, we hope you won’t need to spend it all while you are still working. This allows your HSA balance to grow and be available when you retire.
There’s good reason to keep these funds in reserve. As touched on above, after you reach age 65, the HSA behaves like a typical retirement account for non-medical expenses, with withdrawals subject to ordinary income tax. It also offers the added feature that withdrawals for medical expenses are tax free. And, again, it’s not subject to a required minimum distribution.
Prioritize Your Retirement Plans
While the HSA can be a valuable tool for optimizing your retirement savings, we’re not suggesting it should replace them. Most people should save for both. That said, we understand this is often easier said than done. In addition to an HSA, you may have many choices for retirement savings: a 401(k), 403(b), 457, IRA, Roth IRA, SEP and others. Most people can’t afford to contribute the maximum allowable to each account every year.
As a general rule of thumb, because of its unique tax benefits, we typically suggest the HSA should be toward the top of your saving priorities. If your employer has a retirement plan, such as a 401(k), a good start may be to contribute at least enough to earn your employer’s match. Then contribute as much as you can to your HSA account. Most people should contribute at least 10–15% of their wages into a 401(k) or similar account, in addition to contributing to an HSA. You are likely to achieve financial security even faster if you can contribute the maximum allowable to both.
Our HSA Recap
You probably don’t need a financial pro to know that healthcare is a big budget item throughout your life and especially in retirement. According to Fidelity, a retiree couple can expect to pay $1,000 per month on healthcare, and $245,000 in their lifetime.
While we hope they do, it’s unlikely these figures are going to drop dramatically in our lifetime. An HSA account is a great way to save for future health expenses, pay for them tax-free, and make good use of whatever is left within your overall, efficient retirement planning. That’s why, when it comes to pursuing financial security, building financial freedom and saving in your HSA, we usually advise families to do so, early and often. Here’s to your good health!