By Joe Delaney
A Health Savings Account (HSA) is a bank account for future health expenses that - at least as far as the federal government is concerned - you can fund tax-free, that enjoys growth tax-free, and from which you can draw funds for qualified expenses tax-free.*
It may be something you’ve only thought about as a feature of low-premium, high-deductible, employer-provided health insurance. But in the context of retirement planning, the power and potential of HSAs to protect your financial future makes two things clear:
- If you have routine medical expenses, you should consider how HSAs allow you to control how you pay for those expenses using untaxed dollars.
- Even if you don’t have significant medical expenses now, this is still an essential retirement savings device considering the expenses you’re nearly bound to have in later life.
For virtually everyone, HSA benefits are three-fold: you can fundit tax-free* during working years, grow it tax-free* as you approach retirement, and you can use tax-free disbursementsto cover medical costs in retirement.
HSA Tax Advantages in Working Years: Funding
High-deductible health insurance plans (HDHPs) today have great advantages – despite the reaction you may have to the “high deductible” part. These plans allow you to control your investment in your health with an HSA tax-free* while cutting the cost of coverage you may not need.
You can fund your HSA and reduce your tax burden in one of two ways:
- Instruct your payroll department or provider to fund it. This reduces your tax liability immediately. Paycheck tax withholdings are calculated based on your income after your HSA contribution is deducted.
- Fund it yourself and claim your contribution on your annual tax return.This reduces your tax liability at the end of the year. If you’re self-employed, this will likely be how and when you’ll enjoy the tax advantage.
Unlike with an IRA or 401k, HSA contributions are also not counted as income in your FICA (Federal Insurance Contributions Act) calculation, meaning you will pay lessinto Social Security and Medicare.
What you’ll have is not only a reduction in annual taxable income (by as much as $3,500 for yourself or $7,000 for your family), but a fund for your future medical expenses that you control. People often spend less over time by banking dollars for health issues down the road that would have otherwise been spent today on insurance premiums.
Generally speaking, people without an ongoing medical condition (such as those who require routine physical therapy) don’t need an insurance plan that lowers the deductible for those services. People without a long-term illness don’t need a plan to lower the deductible on medication and frequent visits to the doctor.
Best to consider that high-deductible plan a backstop against the cost of an unlikely catastrophic event, like a sudden illness or accident, and put these dollars that would have otherwise gone to an expensive low-deductible plan (aftertaxes) into a fund (of untaxeddollars) you control.
That’s the power of the HSA in your working years. But it gets even better as you age.
HSA Tax Advantages Pre-Retirement: Growth
As you approach retirement and continue to fund your HSA, you will enjoy tax-free growth in this account. When you have a small qualified medical expense and pay for it with a distribution from this account (with a debit card or check offered by your provider), that distribution will alsobe tax-free.
Keep Accumulating Year Over Year
You also have no requirement to use funds each year (as you do with a Flexible Spending Account, which adds additional qualified expenses but with a must-spend caveat). In other words, with an HSA, you lose nothing as you go.
Invest the Balance
As you grow your HSA, you can invest a portion of the balance in taxable or tax-deferred accounts, just like you can with a 401k. This is a great way to invest in your long-term success.
A good fiduciary advisor looks at your HSA as part of the big picture: a diverse portfolio that includes both cash on hand for medical expenses andinvestments in stocks and bonds within your risk tolerance aimed at maximizing long-term growth. The money in your HSA isn’t either-or. It can be both.
Part of a Comprehensive Portfolio
In general, moving money out of your HSA makes sense if the expected returns less taxes and fees are greater than the value of keeping those tax-free health savings on hand. The closer you are to retirement (or the more health expenses you have), the greater the value of having that money available for disbursement.
For most people, retirement is when the value of the HSA shines brightest.
HSA Tax Advantages in Retirement: Disbursement
This stage of life, when medical expenses are practically guaranteed, is when having a robust HSA can really pay off. You’ll not only be able to use a fund that you accumulated tax-free* on those guaranteed expenses tax-free, but the definition of “qualified expenses” will expand.
For the first time, premiums will count as a qualified expense– specifically, Medicare premiums. (There may be other premiums that count as a qualified expense at age 65 or older as well. Consult your tax professional.)
As Michael Kitces points out, the benefit of growing a tax-free account that will pay for Medicare premiums is so great, it may make sense to defer your HSA distributions specifically for this.
When an HSA Becomes an RHSA
The best strategy for some (not everyone) with only minor medical expenses may be not to use it to pay for those. Instead, it can be a good strategy to pay for those out of pocket as you treat your HSA exclusively as a retirementhealth savings account.
When utilized as a retirement account (like an IRA or 401k), the HSA’s unique tax-free nature makes it every bit as valuable as the others in this category. Sometimes more so.
Over time, the net growth of a retirement health savings account can actually beata traditional retirement account – even a 401k bolstered by a company match!
Kitces explains it this way, with the aid of this graph from his website:
“For instance, if a contribution to a 401(k) offers a 25% match, but the individual faces a future tax rate of 20%, then $1 contributed to a 401(k) is still only worth $1 in after-tax value (as the match increases it to $1.25 but the taxes decrease it back to $1). Which is exactly the same as simply contributing the $1 of pre-tax income to an HSA, also worth $1 of after-tax value. In turn, this means at any tax rate higher than the aforementioned 20%, it’s actually better to contribute to the HSA than to get the match with the 401(k).”
It’s important to understand this is notthe case with everyone. For account holders with significant medical expenses, it often makes the most sense to use those tax-free dollars to pay for them as you go.
No Matter How Far Along You Are in Retirement Planning, It’s Time to Invest In a Health Savings Account
While it has similarities to other kinds of accounts, there is nothing quite like an HSA.
● It reduces your tax liability in working years.
● It grows tax-free while giving you the option to invest it in potentially faster-growing investments.
● It pays your Medicare premiums and other nearly guaranteed medical expenses in retirement.
If you can’t already tell, we are HSA enthusiasts here at Lifeguard Wealth!
Contact us today. We’d be delighted to give you customized recommendations on where to open your HSA, and how to use it to maximum effect as part of a comprehensive, lifelong plan for wealth security.
*HSA contributions and earnings are not taxed by the federal government, or by most states. At the time of writing, California and New Jersey dotax eligible contributions, and New Hampshire and Tennessee dotax HSA earnings. This information is subject to change. Consult a tax professional for details.
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