Note: This is an updated version of this blog: Health Savings Accounts: An Often-Overlooked Tax Benefit. This blog was also updated in April 2023. The most up-to-date version can be found here. The IRS limits for Health Savings Accounts and High-Deductible Health Plans have been updated. Some additional information is also provided.
The most common way to save for retirement through our employers is a workplace retirement account such as a 401(k) or a 403(b) plan. If we are self-employed, we might use a Keogh or a self 401(k) plan instead. However, these conventional ways to save may not represent the best choices. If you are employed and can realize similar rates of return, you may be better off contributing to a Health Savings Account (HSA) before funding conventional retirement accounts. (Note that depending on the actual circumstances, if your employer provides some sort of match to your contributions, you should take advantage of that benefit first.)
In an earlier post where we shared some tax-planning tips, we mentioned the benefits of contributing to an HSA. We thought it would be worth expanding on the benefits of including HSAs as part of your financial plan.
The tax rules drive this thought process. Contributions made to HSAs not made by your employer are tax deductible. You can make tax-free withdrawals from HSAs free if you use the money to pay for qualified medical expenses. Importantly, medical expenses for this purpose generally include qualified expenses incurred any time after the plan was established. While contributions to 401(k) plans are tax-free, withdrawals are taxed at ordinary income tax rates.
Of course, it may not work out quite as easily as described above. As genie said in Aladdin, there may be a couple of quid pro quo or caveats.
· Depending on the available investment options and the associated fees, the expense-adjusted returns for an HSA might not be as high as they are for a 401(k) or 403(b) account.
· The number of investment options may also not be as varied in your HSA.
Once you reach retirement, you can withdraw money from your HSA to pay for qualified medical expenses. These withdrawals are tax-free. That means you don’t have to make a taxable withdrawal from your IRA or 401k. This can also help keep you from being bumped into a higher tax bracket.
Key Points:
· Health Savings Accounts Are Different Than Flex Spending Accounts.
· Health Savings Accounts Are Triple Tax-Free.
· A family can contribute up to $7,200 annually to a Health Savings Account – more if you are 55 or over.
· To get the optimal benefits from a Health Savings Account, you should invest the money for the future. You want to refrain from using it in the same year as you contribute money to the account.
What Is a Health Savings Account?
HSAs are tax-sheltered savings accounts available to those enrolled in high-deductible health plans (HDHP). We will explain more about what an HDHP is later. For now, understand that an HDHP charges lower premiums than traditional insurance plans. It also comes with higher deductibles and out-of-pocket maximums. An HSA provides tax benefits to help defray these higher costs.
Contributing to a Health Savings Account Can Make Sense
Many people overlook HSAs as retirement savings vehicles by using them to pay current medical bills. However, the accounts, which became effective as of January 1, 2004, come with more tax advantages than 401(k)s and individual retirement accounts when used to cover medical costs – whether now or in retirement. Even better, they can create tax-free income.
Medical costs can represent a major retirement expense. According to the latest retiree health care cost estimate from Fidelity Benefits Consulting, a 65-year-old couple retiring in 2021 and expecting to reach their life expectancy, will need approximately $300,000 (in today’s dollars) to cover medical expenses throughout retirement. That estimate applies only to retirees with traditional Medicare insurance coverage. It does not include costs associated with nursing home care.
Health Savings Account: The Triple-Tax Benefit
HSAs offer a triple tax benefit, making it one of the tax code’s most tax-favored savings vehicles:
1. Assets contributed to HSAs can grow free of taxes.
2. Savers can contribute to them on a pre-tax or tax-deductible basis.
3. Account holders can withdraw the assets free of taxes, provided the money goes toward (or is offset by) qualified medical expenses.
Given those tax benefits, some financial planners argue that, if you have the financial wherewithal to do so, you should leave your HSA undisturbed. Instead, you should use after-tax, non-HSA dollars to cover healthcare costs as incurred. This strategy allows you to take maximum advantage of the tax-saving features of your HSA. You should spend less-tax-efficient taxable assets instead.
An Example of the Savings and Benefits Provided by Health Savings Accounts
Assume you are single, and your taxable income is $95,000. In 2021, your marginal federal income tax rate is 24%. If you live in Baltimore County, Maryland where Apprise Wealth Management is based, your marginal tax rate for state and local taxes is 7.77%. You will also pay FICA tax (which finances Social Security and Medicare) at 7.65%. The result: you only get to keep about $0.61 of every dollar you earn.
If you put money in your HSA, you can shelter 100% of every dollar you save in your HSA forever if you use the money to reimburse qualified medical expenses.
Assume you save $3,000 in your HSA this year, and it grows at an annual inflation-adjusted rate of 4%. If that money stays in the account for 20 years, it will be worth $6,573. If you saved the same $3,000 in your 401(k), you will pay federal and state income taxes when you withdraw it in 20 years. Assuming the same federal and state rates as above), you would only have $3,987. Remember that this example only covers one year, too.
In other words, the returns you get from an HSA can grow and produce higher returns than those available from other accounts. Why? You don’t pay any taxes on the amount you put into your HSA. You also don’t pay taxes when you withdraw the funds, as long as they are used to pay for qualified medical expenses.
Even if you decide to use the HSA to pay current medical bills, it still makes sense to contribute. Why? The upfront tax deduction (roughly 39%) allows you to keep the money you would have otherwise had to pay in taxes.
What is a High-Deductible Health Care Plan?
In 2021, a high-deductible health care plan (HDHP) has a minimum annual deductible of $1,400 for individuals and $2,800 for families. The plan must have annual out-of-pocket expenses (deductibles, copayments, coinsurance, and other amounts but not premiums) totaling less than $7,000 for individuals and $14,000 for families. Note that this limit does not apply to deductibles and expenses for out-of-network services if the plan uses a network of providers. Only deductibles and out-of-pocket expenses for services within the network should be used to figure whether the limit applies.
How Much Can I Contribute to my Health Savings Account?
In 2021, individuals in high-deductible health care plans can save up to $3,600 in their HSAs. Those with family plans can save up to $7,200. You can contribute up to the limit regardless of your income, and your entire contribution is tax-deductible. You can even contribute in years when you have no income. You can also contribute if you’re self-employed.
If you have an HSA and you’re 55 or older, you can make an extra “catch-up” contribution of $1,000 per year. A spouse who is 55 or older can do the same, provided each of you has his or her own HSA account.
Unlike the use it or lose it rules that apply to amounts contributed to flexible spending accounts, amounts contributed to HSAs can roll over to the following year.
How Can You Use the Amounts in Your Health Savings Account?
1. You can withdraw money from the account to cover ongoing health expenses.
2. You can pay for ongoing health expenses with non-HSA funds. This allows the amount in the HSA to accumulate over time.
Treating your HSA as an investment account instead of a short-term expense account allows you to invest the funds. They can then grow into another source of retirement funds or to cover medium- to long-term health care expenses. This approach also provides the greatest growth potential. That is why, to the extent possible, you should try and avoid spending these funds now. If you have an emergency or other very large medical expense, you can use your HSA funds, if necessary.
Moving the Money from your Health Savings Account
HSA assets are portable – savers can take the money with them when they change jobs. Investors can also move the money to a different custodian and allow their financial advisor to have oversight of the account. There are three ways to transfer assets into an HSA:
1. You can move the funds via a trustee-to-trustee transfer, in which one custodian wires the assets to another. Savers are allowed an unlimited number of these transactions; they are not rollovers.
2. Account holders may receive a rollover check from their custodian and deposit the money into a new HSA within 60 days. You can only complete such transactions once a year.
3. Investors may make a once-in-a-lifetime transfer of savings from an individual retirement account into an HSA. The amount transferred cannot exceed that year’s contributions limits as described above. (For example, if you are over 55, you could transfer $8,200 in 2021.) This transfer is also referred to as a Qualified HSA Funding Distribution (QHFD) from an IRA. Note that these rules do not apply to ongoing SIMPLE or SEP IRAs. After a QFHD, an individual must remain HSA eligible for a one-year testing period to avoid taxes and penalties.
The Ability to Pay for Almost Anything Tax-Free from your Health Savings Account
If you keep good records, you can use your HSA to pay for almost anything tax-free throughout your career. If you keep your medical expense receipts, you can withdraw funds from your HSA in a future year.
You want to be careful about double-dipping as well. You can only claim an expense once.
You do not need to have current medical expenses; you merely need to have a receipt from any time in the past to get reimbursed. Qualified medical expenses can arise from any year (starting with the year the HSA is opened– not just the current one. This proactive strategy allows an HSA holder to supplement retirement income tax-free rather than withdrawing money from a taxable 401(k) plan account. This could also help keep tax rates lower, as additional taxable withdrawals from a 401(k) account can bump the holder into a higher tax bracket. It may also help you limit your Medicare premiums.
Contributions to your Health Savings Account Can Be Made After Year End
There are other ways in which HSAs provide flexibility. Like with an IRA, taxpayers have until April 15th to make contributions for the previous tax year. For example, assume a married 58-year old self-employed worker had $5,000 in medical expenses and paid for them with after-tax, out-of-pocket money. After meeting with her financial advisor she learned of her eligibility to contribute to an HSA.
As a result, before filing her tax return in April, she can establish an HSA and contribute $5,000. This would lower her federal and state income tax bill. She could even withdraw the $5,000 from her HSA and reimburse herself.
As a result, she would lower her tax bill. While this approach is not as beneficial to a long-term financial plan as leaving the money in the account would be, it is still worthwhile.
Note that making a prior year contribution requires you to take a simple, but special, action with your HSA custodian. When you make the contribution, you must indicate specifically that it applies to the prior tax year. This is because a contribution made in say, January, can be used for either the current year or the prior year. When you make the contribution, there should be an indicator to your custodian of the tax year to which it applies. Make sure you pick the correct one.
Other Advantages of Health Savings Accounts
· Family Coverage: HSA holders can use assets from their own HSAs to pay for qualified medical expenses incurred by their spouses as well as dependents even if they are not eligible to establish their own HSAs or even if their insurance coverage is different than that of the HSA holder.
· Flexibility: HSA holders can withdraw HSA assets or change them at any time regardless of their current employer or current eligibility. In addition, there are no required minimum distribution rules or requirements. That means you do not have to start taking withdrawals at a certain age or withdraw a certain amount.
· Full Vesting: Whether they are made by the employee or an employer, contributions to an employee’s HSA are immediately vested to the employee.
· Long-Term Care Insurance: You can also use HSA distributions to pay for Long-Term Care Insurance tax- and penalty-free (however the amount is limited, see IRC 213(d)(10)).
· Medicare/Retirement: The Medicare Part B monthly premium (for doctor visits) is deducted directly from a recipient’s monthly Social Security check. HSA holders can get reimbursed for those costs from HSA assets as well as Part D monthly premiums (for drug prescriptions).
· No Use-It-Or-Lose-It-Rule: Unlike amounts withheld for your flexible spending account, you need not spend amounts contributed to an HSA. Unused HSA funds continue to belong to the owner.
· Portability: A worker can open an HSA anywhere she wants. For example, oftentimes the fees associated with employer-sponsored HSA are too high, and/or the investment options are not desirable. You can withdraw assets from the HSA and invest them elsewhere into a more desirable HSA. You must complete this process within 60 days. It may involve less hassle than a rollover.
· Sources of Contributions: The HSA owner, a family member, or an employer can make contributions.
· Treatment at Death: When an account holder dies, you can roll over the HSA can to a spouse tax-free. That spouse can also continue to save and invest in the HSA. However, if you roll the HSA over to a non-spouse, the account’s balance is fully taxable (like what happens with a retirement plan account).
You Must Keep Track of Out-of-Pocket Healthcare Costs
If your goal is to maximize the balance of your HSA so there is more money left in the account for retirement, you must establish a system to keep track of the out-of-pocket money you spend for current medical expenses. Saving your receipts will allow you to file for reimbursement from your HSA at any time and create tax-free retirement income.
The old-fashioned way to do this would be to store your receipts in a shoebox or file cabinet. If you have a scanner (you can also install a scanning app on your phone or tablet), you can use it to save receipts. Check with your HSA provider as well. Many offer electronic repositories for such receipts.
In general, your records must be sufficient to show that:
· The distributions were used exclusively to pay or reimburse qualified medical expenses;
· The qualified medical expenses had not been previously paid or reimbursed from another source; and
· The medical expenses were not claimed as an itemized deduction in any year.
You do not have to send these records with your tax return. Keep them with your tax records.
It is also important to make sure your heirs know where you keep the information. Spouses, who are named as beneficiaries, can inherit HSAs tax-free. Other beneficiaries may have to pay income tax on the balance they receive following the account owner’s death. Importantly, the account can be tapped tax-free to pay the account owner’s unreimbursed qualified medical expenses within a year of death as well.
How Do You Report Your Health Savings Account Activity to the IRS?
You must file Form 8889 with your tax return if you (or your spouse, if married filing a joint return) had any activity in your HSA during the year. You must file the form even if only your employer or your spouse’s employer made contributions to the HSA.
If, during the tax year, you are the beneficiary of two or more HSAs or you are a beneficiary of an HSA and you have your own HSA, you must complete a separate Form 8889 for each HSA. You must also complete a controlling Form 8889 combining the amounts shown on each of the statement Forms 8889. Attach the separate Forms 8889 to your tax return after the controlling Form 8889.
Investing Your Health Savings Account for Retirement
If your intent is to save your HSA for retirement, you can invest it in a diversified portfolio the same as other retirement plan accounts. If you leave your contributions in a low-risk option like a money-market fund, the account’s growth will likely be minimal. Doing so will mitigate one of the HSA account’s biggest advantages – the ability to grow tax-free.
Unhappy with your investment options? You can transfer your HSA to another financial institution that offers such accounts. You might also want to move your account to avoid high fees. For example, according to a recent Morningstar report, that compares options from 11 large HSA providers, the three most important criteria to consider are maintenance fees, interest rates offered, and additional fees. If you would like other options, check out HSAsearch.com. That database evaluates 685 HSA providers.
Unfortunately, few HSA participants invest the assets held in their HSA accounts. The majority either save their HSA assets in a savings account or use their HSA on an ongoing basis to cover healthcare costs. Very few participants contribute the maximum allowable amount to their HSAs as well.
Are There Any Drawbacks or Limitations to Health Savings Accounts?
There must be a downside to contributing to an HSA, especially because it relates to taxes. Here are some things to remember:
· Limitations on Withdrawals. To withdraw money tax-free, you must use it for qualified medical expenses. These can include medical costs as well as dental- and vision-care expenses, premiums for all types of Medicare plans except for Medigap, and a portion of long-term insurance care premiums.
· Use for Nonmedical Expenses. If you use your HSA for nonmedical expenses, you will owe income tax on the distributions – plus a 20% penalty if you are younger than 65. (Note that the penalty for early withdrawals from an IRA is only 10%.)
· You Must Maintain Records/Receipts. Whether you keep them in paper or electronic form, you need to have support for any reimbursed expenses. But, if you do, and you have been contributing for a long time, you can use the money for almost anything. You could buy a boat, go on a special vacation, or anything else you want to enjoy during your retirement years.
· Medicare Ineligible. Beginning with the first month you enroll in Medicare, your contribution limit is zero.
· When you retire, you may want to spend down your HSA first. You can pass your HSA to your spouse if you die. He or she can then use it for qualified medical expenses. For non-spouse survivors, the account loses its HSA status, and its fair market value becomes taxable to the beneficiary. However, the beneficiary can use the HSA funds to pay for the account holder’s medical expenses for up to 12-months after their death.
Tax Treatment of Health Savings Accounts May Vary by State
The strategies described in this article are based on federal tax law. Most states follow federal tax law when it comes to HSAs, but yours may not. At the time of writing, California, and New Jersey tax HSA contributions. Alaska, Florida, Nevada, New Hampshire, South Dakota, Tennessee, Texas, Washington, and Wyoming don’t have state taxes, so the state tax benefit is not applicable. New Hampshire and Tennessee tax HSA earnings if you make a taxable withdrawal from your account. Even if you live in a state that taxes HSAs, you still qualify for federal tax benefits.
Can I Use My Health Savings Account to Fund Insurance Premiums?
With some exceptions, insurance premiums related to the following types of insurance or events may be considered qualified medical expenses:
· Long-term care insurance: However, such amounts are subject to limits based on age and are adjusted annually.
· COBRA: Healthcare continuation coverage (such as coverage under COBRA).
· Unemployment: Healthcare coverage paid while you are receiving unemployment compensation under federal or state law.
· Medicare: If you are 65 or older, the cost of Medicare and other health care coverage (other than premiums for a Medicare supplemental policy, such as Medigap).
Many of the rules surrounding an HSA or a QHFD are complex, so we recommend consulting with a professional before acting and again when filing your return. If you want to do more research, you can review IRS Publication 969.
Concluding Thoughts
If you have a high deductible health care plan, you should open an HSA. HSAs can play an important role in your financial plan and help you be better prepared for retirement. Since they are triple tax-free, HSAs can provide greater tax benefits than other retirement savings vehicles.
If you have any questions about HSAs, you can schedule a free call or virtual meeting via Zoom by clicking this link. You can also complete our contact form, and we will be in touch.
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Phil Weiss founded Apprise Wealth Management. He started his financial services career in 1987 working as a tax professional for Deloitte & Touche. For the past 25+ years, he has worked extensively in the areas of financial planning and investment management. Phil is both a CFA charterholder and a CPA.
Located just north of Baltimore, Apprise works with clients face-to-face locally and can also work virtually regardless of location.
