I have a client who describes her Traditional IRA as silver and her Roth IRA as gold. And I think it’s an excellent analogy for how to think about assets earmarked for retirement. But what if there was a platinum category within your retirement portfolio? Let’s look at HSAs and their role within your retirement portfolio.
A health savings account (HSA) is an account that is used in conjunction with a high-deductible health plan. It allows the participant in the high deductible health plan to set aside funds on a pre-tax basis to be used for qualified medical expenses without incurring income taxes. However, this is a great example of Shakespeare’s quote, “A rose by any other name would smell as sweet.” These accounts may be called Health Savings Accounts – but they can function as great retirement savings accounts. These may be the platinum category of retirement accounts.
HSAs as part of your Retirement Portfolio
Let’s consider how HSAs are similar to qualified retirement accounts. As long as you qualify to contribute to an HSA, your contributions are not subject to income tax. Additionally, these contributions are not subject to Medicare tax or FICA. Your contributions to the account are subject to a dollar limit each year, and the dollar limit differs depending on whether the account is established for an individual or a family health plan. However, just like retirement accounts, HSAs are always owned by a single individual; there are no jointly owned HSA accounts. Once funds are in the account for a period of time that is specified by the HSA plan, they can be invested. As we know, reimbursements from the account for medical expenses will be tax-free, including reimbursements from the growth portion of the account. Meaning that as long as you have qualified medical expenses for which you can reimburse yourself from the account, the growth will never be taxed.
Important considerations
Some important things to note about HSA accounts are that an HSA account is not a “use it or lose it” account (unlike FSA accounts), and the medical expenses being reimbursed do not have to occur in the same year as the contribution. These factors can provide significant benefits in retirement planning.
If your cash flow permits, leaving the funds in your HSA account each year, investing them, and allowing them to potentially grow while delaying submissions for reimbursements from the account until retirement opens a huge opportunity for tax-free funds in retirement. The first part of this strategy requires that you have other funds to pay medical expenses each year that you have an HSA. You will save receipts for medical expenses incurred during those years until you ultimately reimburse yourself from the account in retirement. This includes receipts from all expenses incurred from the time that you opened the HSA account.
The second part of the equation involves investing the funds in the account. Once the funds have been in your HSA account for a period of time (specified by your plan), you are permitted to invest the funds within the HSA account. The growth resulting from your investments will be available for tax-free distribution as medical expense reimbursements, much like the tax-free distribution of growth from a Roth IRA account.
The third part involves reimbursing yourself for accumulated medical expenses when you choose or when you need additional income in retirement. Medical expenses in retirement, including Medicare premiums, also count as qualified medical expenses. But, as we said above, your reimbursements don’t have to happen in the same year as a contribution or even in the same year as the medical expense. You could accumulate medical expenses for years and then submit them for reimbursement years later. This could result in nontaxable income in retirement, which can be used for any purpose.
One of the reasons that an HSA account is seen as even better than a Roth IRA account is that the original contribution allows you a tax deduction, much like a traditional IRA. And the distribution, if it meets the requirements, is also free of taxes much like a Roth IRA. In addition, that contribution and the distribution are both free of FICA and Medicare taxes. Furthermore, if your HSA reimbursement is for qualified medical expenses, the distribution amount does not appear on your tax return and, therefore, does not affect your Adjusted Gross Income. This is important because Medicare premiums and the degree to which your social security income is taxed are dependent on your Modified Adjusted Gross Income.
Potential Drawbacks
While HSAs have their benefits, there are also some drawbacks. The first is the requirement that you are covered by a high deductible health plan (HDHP) and no other health insurance. This means that you are not eligible for an HSA account if you are covered by an FSA account – even if it is your spouse’s FSA account. And, with high deductible plans you could be responsible for covering significant medical expenses, and you should plan for the possibility of those expenses.
Another potential drawback is the required recordkeeping. You must maintain the receipts for your medical expenses until you ultimately reimburse yourself for those expenses and then for the length of time beyond filing your tax return as required by the IRS for maintaining your tax return records.
Furthermore, while the list of qualified medical expenses is extensive, you must actually have medical expenses for which you can reimburse yourself when you want to take a tax and penalty-free distribution. If you take a distribution that is not a reimbursement for qualified medical expenses prior to reaching age 65, you will pay income tax and a 20% penalty on the withdrawal. Once you reach age 65, you can withdraw HSA money without qualified medical expenses and only pay income tax on the withdrawal; no penalty applies once you reach age 65.
And, finally, HSA accounts often have expenses. There may be plan expenses, investment expenses, and even transaction fees for each distribution.
Other features to keep in mind
- The account is yours. There are no vesting rules. If you leave your employer, the account is still fully yours.
- There are no Required Minimum Distributions. Unlike Traditional IRAs, you are not required to take distributions from the account when you reach a particular age.
- You cannot make contributions to the account if you are covered by Medicare. However, Medicare premiums are considered qualified medical expenses for the purposes of reimbursement from your HSA.
- Your employer can contribute to your HSA. However, the annual contribution limits apply to the total amount contributed each year, including both your contribution and your employer’s contribution.
Consider a health savings account (HSA) as part of your retirement portfolio. With planning, HSAs can provide additional flexibility and, potentially, nontaxable income in retirement.
This article is intended to be educational and thought-provoking rather than financial advice. When we work together in a financial planning engagement, we discuss your unique personal situation and your unique goals. We examine these factors and many others during our financial planning process to determine appropriate financial strategies for YOU.