The Retirement Advantages of Health Savings Accounts

The Health Savings Account (HSA) could be the best retirement planning vehicle available. Only the Roth IRA comes close.

People are catching on to the advantages.There now are over $40 billion in HSAs, and the number of HSAs increased 16% over the last year. Much of the increase is because employers are switching to high-deductible health plans, and HSAs are designed to supplement those plans.

Yet, people aren’t reaping all the advantages of HSAs.

The best way for most people to use an HSA is as a retirement savings vehicle. During the working years, it’s best to pay for medical expenses out of income and non-HSA savings when possible. Let the HSA accumulate and compound for retirement.

The HSA is the only savings vehicle with three tax advantages.

There’s a tax advantage when money is contributed to the account. When you make a contribution, it is tax deductible. When your employer (or anyone else) contributes to your HSA, the contribution is tax free to you. Unlike when you defer salary to a 401(k), the HSA contribution isn’t even subject to Social Security and Medicare taxes.

The second advantage is the HSA and can be invested, and the income and gains aren’t taxed while they remain in the account.

The third advantage is distributions from the HSA are tax free when used to pay or reimburse you for qualified medical expenses.

You’re likely to pay more in medical expenses during retirement than during your working years. It makes sense to do some of your retirement savings through an HSA. Then, during retirement, begin taking tax-free distributions as needed to pay medical expenses.

Qualified medical expenses would be deductible as itemized medical expenses on your income tax return. It can pay for expenses not covered by Medicare or other insurance, including dental and vision expenses. The account can pay Medicare Part B premiums, even if they are deducted from your Social Security benefits. Simply reimburse yourself for the premiums. Premiums for Part D prescription coverage and Part C Medicare Advantage plans also qualify as tax-free distributions. But premiums for Medicare Supplement (Medigap) plans aren’t qualified medical expenses. If you have questions about qualified medical expenses, review free IRS Publication 502, available at www.irs.gov, or ask your HSA administrator.

HSAs have advantages in addition to the big three tax benefits.

There are no required minimum distributions. The HSA balance can accumulate until you need it.

The HSA can pay for nonmedical expenses. When distributions from an HSA are used to pay for anything other than qualified medical expenses, the distribution is included in gross income, but there’s no penalty if the distribution was at age 65 or after. There’s an additional 20% penalty when you’re under age 65 and take a distribution for non-medical expenses.

When you pass away, the account balance goes to the beneficiary you named. The tax treatment depends on who your beneficiary is.

When you don’t name a beneficiary or name your estate, the HSA will be distributed to your estate. The entire amount will be included in gross income on your final income tax return.

There’s better treatment when your spouse is the beneficiary. The account will remain an HSA, and your spouse will be its new owner. Distributions to pay or reimburse qualified medical expenses will continue to be tax free. When your spouse is 65 or older, distributions for non-medical expenses will be included in gross income, and when the spouse is under age 65, distributions for non-medical expenses also will face a 20% penalty.

When the beneficiary isn’t your spouse, the account stops being an HSA on the date of your death. The account balance is distributed to the beneficiary and included in gross income. Any qualified medical expenses you incurred before passing and that the beneficiary pays within one year of your death can reduce the taxable amount.

An HSA can be opened only when you are covered by a high-deductible medical insurance plan, whether it is through an employer or an individual policy. Not all “high deductible” insurance plans qualify you to open an HSA, so it’s important to verify with the plan administrator or insurer that it is an HSA-eligible plan.

Despite the rising use of HSAs and their many benefits, too many HSA owners don’t reap all the advantages of their accounts.

Like an IRA, an HSA has to be maintained by an administrator or custodian, and each offers different terms. When opening an individual HSA, choose carefully the administrator or custodian. Morningstar did a study of major HSA providers recently and was unimpressed. Some charge monthly fees that quickly can eat away the value of the HSA. Others offer very limited investment options. Check the investment choices and any fees associated with them.

Many people have their HSAs invested in cash. While you don’t want to take a lot of risk with the account (unless you’re fairly young and believe you won’t need the money for years), you should consider investing to earn a little more than cash pays.

Also, investigate the spending and reimbursement options. Many HSAs now offer a free debit card and a checkbook. You can pay for medical expenses by using either the debit card or writing a check. The checks also can be used to reimburse yourself for covered expenses you paid. You also might be able to link the HSA with one or more of your other financial accounts. For example, after incurring a qualified expense you can transfer money to your checking account, either online or by telephone.

While many custodians offer those easy ways to take tax-free distributions, some don’t. Some HSAs require you to complete a distribution request before they’ll issue a payment.

I recommend taking a look at HSA Bank and The HSA Authority. Each is a relatively small bank that offers HSAs with good terms nationwide and good investment options. Also, consider Health Savings Administrators.

The maximum contribution in 2018 is $3,450 for an individual policy or $6,900 for a family policy. Account owners who are 55 or older can add $1,000 to those limits.

There’s an IRA rollover option available to someone who wants to fund an HSA but doesn’t have the cash. You can roll over from a traditional IRA to an HSA an amount up to the year’s annual contribution limit.

The rollover will be tax free. But this option can be used only once in a lifetime. And the rollover, plus any other contributions for the year, can’t exceed the year’s contribution limit. As you reach age 65, you should know that once you enroll in Medicare, no contributions are allowed to your HSA. Most people need to enroll in Medicare at age 65 to avoid paying higher premiums for life by signing up later. In addition, you’re automatically enrolled in Part A when you file for Social Security retirement benefits.