As open enrollment for the Affordable Care Act begins this month, whether you get your insurance from the Health Insurance Marketplace or through your employer, now is a good time to consider your health insurance options for next year if you haven’t already. You may have seen plans that are listed as HSA-eligible. What many people don’t realize is the HSA is one of the best ways to save for retirement.
What is an HSA and Why You Need One
A health savings account (HSA) is a tax-advantaged medical savings account for people who are enrolled in a high-deductible health plan (HDHP) to help pay for medical expenses. The money contributed to the account is not subject to federal income tax.
Unlike a flexible spending account (FSA), where the money you contribute is forfeited to your employer at the end of the year if it is not spent, an HSA belongs to you and any contributions you make will remain in the account forever until you withdraw it for medical expenses. This includes using an HSA during retirement.
According to the Employee Benefit Research Institute (EBRI), 20.2 to 22.6 million people enrolled in high-deductible, HSA-eligible health plans in 2016. Yet the average HSA balance at the end of 2016 was only $2,532 and only 3% of HSAs had invested assets. This means that since the HSA was first offered in 2004, the average account has a balance of less than the 2004 max annual contribution of $2,600 for an individual. What this tells you is that just about everyone takes distributions from their account to pay for current medical expenses.
While taking out contributions to pay for medical expenses was what the creators of the health savings accounts had intended for them to be used for, these people are missing out on an incredible opportunity to pay for their medical expenses in their later years when medical costs can be expected to be much, much higher.
The latest retiree health care cost estimate from Fidelity shows that a 65-year-old couple who retires in 2017 will spend $275,000 on medical expenses in their retirement, an increase of $15,000 from 2016. Imagine how much medical costs will be in the future if you are only 30 years old right now.
Why is the HSA a Great Way to Save for Retirement?
HSAs are similar to tax-advantaged accounts such as 401k plans and traditional IRAs that are commonly used to save for retirement. What makes HSAs better is that they are triple tax-advantaged:
Contributions to an HSA are Tax Deductible
If they are made through a payroll deduction, your contribution amounts are pretax, and any funds that your employer contributes to your account are excluded from taxable income. And unlike IRAs, there are no income requirements to contribute to an HSA, so you can still take the deduction even if you are an early retiree and living off your savings and dividends.
Funds in your HSA Grow Tax-Free
Some HSA providers offer interest for money deposited into accounts with their company, and others will even allow you to invest unused funds into mutual funds, stocks, and ETFs. Any interest, dividends, and capital gains earned are not taxed just like 401k’s and IRAs.
Withdrawals for Qualifying Medical Expenses are Always Tax-Free at Any Age
This is what makes an HSA a better option for retirement savings than a 401k or IRA because when you withdraw funds from those other plans, you will have to pay taxes on that money. The taxman has been eyeing all that money that has been accumulating in your retirement accounts over the years and now he wants his money.
It doesn’t matter if you have plenty of savings elsewhere to pay for retirement. If you are over 70½, you are required to start taking distributions from your 401k or IRA and pay your taxes.
With an HSA, you cannot contribute any more to the account once you enroll in Medicare coverage at 65, but you can choose to keep the funds untouched in the account for as long as you wish. After turning 65, you may also take money out of your HSA for non-medical expenses penalty-free, but you will have to pay income taxes on the distribution.
Contribute The Maximum Into Your HSA
For 2020, the HSA limits are $3,550 for an individual and $7,100 for a family. HSA contribution limits will be increasing to $3,600 for self-only coverage and $7,200 for a family for 2021. People who are 55 or older can contribute an additional $1,000 per year as a catch-up contribution.
To get the most out of your HSA as a retirement account, you should deposit the maximum each year you are eligible to contribute to an HSA and invest the money into low-cost index funds. Then instead of using it to pay for current out-of-pocket medical expenses, allow that money to compound tax-deferred into a giant pile of money by retirement.
You can use our compound interest calculator to get a quick picture of how much your money could grow into over the years.
If you are currently making contributions to a 401k and don’t know if you can put aside money for an HSA too, one thing you can consider doing is depositing the max for your 401k to get your employer’s match. Then switch to making contributions to your HSA and go back to making contributions to your 401k when you’ve hit the HSA’s yearly limit. This could be a good idea because HSA funds spent on non-medical expenses after 65 are penalty-free and taxed as income upon withdrawal just like a 401k.
With medical bills being the leading causes of bankruptcies, having tax-free funds easily accessible without an early withdrawal penalty is extremely convenient. On the flip side, you can also argue that you might not want to do this because you can take a loan from your 401k or make a hardship withdrawal. The early withdrawal penalty from a 401k is only 10%, while an HSA’s penalty for non-medical expenses before 65 is 20%.
Wait As Long As Possible Before Spending Your Contributions
Some of you might be thinking you have qualifying medical expenses now and you don’t want to lose that tax-free distribution. Well, you don’t have to!
In the 2004 IRS Bulletin, the IRS has stated that there is no time limit to when you can take a tax-free distribution from an HSA as long as the qualified healthcare expenses were incurred after the HSA was established.
Q-39. When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?
A-39. An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year.
What this means is, you’ll want to set up a health savings account as soon as possible and then save all your receipts. Better find a big shoebox.
How To Qualify For An HSA
When shopping for a health insurance plan for 2021 you will need to find a high-deductible health plan (HDHP) that meets the IRS guidelines. This means that the HDHP minimum deductibles must be at least $1,400 for a self-only plan and $2,800 for a family plan. The out-of-pocket maximum cannot exceed $7,000 for self-only coverage and $14,000 for family coverage.
Other requirements you need to meet are:
- You are covered by an HSA-qualified HDHP on the first day of a given month.
- You are not covered by any other non-HSA-eligible health plan that provides any benefits provided by your HDHP plan, such as a spouse’s plan. Some insurance plans such as accident, disability, dental, vision, and long-term care are permissible.
- You are not enrolled in Medicare or TRICARE
- You have not received VA benefits within the past 3 months for any non-service-connected disabilities, except for preventive care.
- You are not eligible to be claimed as a dependent on anyone else’s tax return.
- You are not covered by a general-purpose health care flexible spending account (FSA) or health reimbursement account (HRA), although a limited-purchase FSA or HRA might be permitted.
Not all HDHP plans are HSA eligible. You can look for plans with “HSA” in the title, or if you are shopping on the healthcare insurance marketplace, you can click the “Refine Results” button on the plan listings and check the box for “Health Savings Account Eligible”. Usually these will be bronze or silver level plans.
What I Will Be Doing For 2021
Since I’m self-employed, I will be choosing a plan from the healthcare marketplace for 2021 and because I am in good health, I will be going with a bronze plan. In my state, the monthly premium for an HSA-eligible bronze plan is only $15 per month more than a similar non-HSA plan from the same company. This makes it a no-brainer to go with the HSA-eligible plan. For someone in the 25% tax bracket, deducting the $3,600 contribution to a HSA could reduce their federal taxes by $900.
By choosing a bronze plan, I will also have the lowest possible premiums, and deducting my HSA contributions will also reduce my annual gross income (AGI). If your AGI is no more than 400% of the federal poverty level, you will also qualify for federal subsidies to help pay for your health insurance premiums. These premium subsidies are determined by taking the second-lowest cost silver plan (SLCSP) in your state.
A health savings account’s triple tax advantage makes it a tremendous tool for reducing your taxes today, saving and investing for the future, and paying for high medical costs in your retirement years without paying taxes.
While it is tempting to treat your HSA like a FSA and use it to pay for your current medical expenses, investing your contributions and allowing your balance to grow tax-free can provide significantly more money when you are likely to need it most.
Do you have an HSA? Do you take withdrawals from your HSA to pay for medical expenses or are you saving it for retirement?