5 Benefits of HSAs for Your Retirement

Discover How HSAs Can Enhance Your Retirement Planning Tax-Efficiently

Health savings accounts (HSAs) are commonly known for covering healthcare costs with pre-tax dollars. However, this tax-efficient savings option can also serve as a valuable tool for retirement savings.

An HSA provides triple tax benefits: you can contribute pre-tax dollars, enjoy tax-free growth on earnings, and withdraw funds tax-free, either now or in retirement, to cover qualified medical expenses.

If you use HSA funds to pay for qualified medical expenses, the withdrawals are tax-free. After age 65, you can also use HSA savings for non-medical expenses without incurring penalties, though these withdrawals will be taxed as ordinary income, similar to a traditional IRA or 401(k). For those under age 65, non-medical withdrawals are subject to a 20% penalty in addition to ordinary income tax.

There are many ways to utilize HSAs effectively, whether you are currently employed, nearing retirement, or already retired and enrolled in Medicare. Here are five strategies to help strengthen your retirement planning with HSAs.

1. Understanding the Triple Tax Advantage and Functionality of HSAs

You can contribute to an HSA if you are enrolled in an HSA-eligible health plan, whether through your employer or in private and public marketplaces. Many people view HSAs primarily as a means to save for current medical expenses not covered by their health plans. However, if you can afford to pay these medical costs out-of-pocket, the triple tax advantage of an HSA makes it an exceptionally powerful tool for retirement savings.

Many people contribute to HSAs pre-tax through payroll deductions, thereby avoiding FICA taxes. If you are enrolled in a qualifying health plan, you can also open an HSA independently and fund it with after-tax dollars, which can then be deducted from your personal taxes. These contributions can grow tax-free and be withdrawn tax-free to cover both current and future qualified medical expenses, including those incurred in retirement. If you are no longer covered by a qualifying plan, you cannot make additional contributions, but your existing HSA funds can continue to grow tax-free.

Furthermore, unlike most flexible spending accounts (FSAs), the funds in an HSA can carry over from year to year without forfeiture. You can earn interest on the funds in your HSA, and the account remains with you if you change employers or retire.

For 2024, the IRS has set HSA contribution limits at $4,150 for individual coverage and $8,300 for family coverage. If you are 55 or older during the tax year, you may be eligible to make an additional catch-up contribution of up to $1,000 per year. Similarly, your spouse, if also 55 or older, can make a catch-up contribution, but will need to open their own HSA. For more details on annual HSA contribution limits, refer to IRS Publication 969.

Given that an HSA is one of the most tax-efficient savings options available, it is advisable to contribute the maximum amount allowed and cover current healthcare expenses using other personal savings. To fully benefit from the power of HSA compounding, avoid withdrawing funds unless absolutely necessary. Additionally, consider investing a portion of your HSA in non-cash investment options for long-term growth potential. For more details, refer to section 3.

2. Designate Savings Specifically for Healthcare

You may have saved for your children’s college expenses using a 529 savings account, a specialized account designed for a specific future expense. Similarly, you might have designated portions of your savings for distinct financial goals such as purchasing a new car, planning a special family vacation, or buying a new home. Each of these financial goals has a different time horizon and should be managed accordingly.

Now consider healthcare. You are likely to encounter various healthcare expenses in the future, including medical procedures, hospital bills, prescription medications, and possibly home healthcare or nursing home costs. The timing and amount of these expenses are unpredictable.

Given the likelihood of incurring significant healthcare expenses later in life, it is prudent to build a dedicated nest egg for future healthcare costs. However, determining the appropriate amount to save can be challenging.

3. Consider Investing Your HSA Funds for Greater Growth

Although healthcare costs are continually rising, there are strategies to prepare for medical expenses in retirement. To do this effectively, it is crucial to start saving early and invest those funds to maximize growth.

If you anticipate needing some of your HSA funds for near-term medical expenses, allocate a portion of your HSA to cash for those immediate costs. Invest the remaining funds to potentially achieve tax-free growth and strengthen your retirement savings.

How do HSAs compare to other savings vehicles? The tax advantages of HSAs offer the potential for greater investment growth and larger after-tax balance accumulation compared to other retirement or healthcare savings options. When HSA funds are used for qualified medical expenses, no federal taxes are incurred, making HSAs one of the most tax-efficient investment options for retirement. For instance, consider a scenario where an individual invests $1,000 in their HSA.

Over the next 30 years, a single investment of $1,000 in an HSA grows at an annual rate of 7%, reaching $7,612. If the same $1,000 were invested in a tax-deferred account like a traditional IRA, the total investment return would also be $7,612. However, after accounting for income taxes at an effective rate of 22% upon distribution, only $5,937 would remain.

4. Planning to Utilize Your HSA in Retirement

While HSA funds cannot be used to pay premiums for all types of health insurance coverage, they can be used to cover qualified medical expenses such as deductibles, copayments, and coinsurance.

1. Bridge to Medicare: If you retire before age 65, you may need health care coverage until you become eligible for Medicare. Generally, HSA funds cannot be used to pay for private health insurance premiums, but there are exceptions. These include paying for health care coverage purchased through an employer-sponsored plan under COBRA and paying premiums while receiving unemployment compensation.
2. Cover Medicare Premiums: You can use your HSA to pay certain Medicare expenses, including premiums for Part A (if applicable), Part B, Part D prescription drug coverage, and Medicare Advantage. However, HSA funds cannot be used for supplemental (Medigap) policy premiums. For retirees over age 65 with employer-sponsored health coverage, an HSA can also be used to pay your share of those costs.
3. Long-Term Care Expenses: Your HSA can be used to cover part of the cost of a “tax-qualified” long-term care insurance policy. This is applicable at any age, but the allowable amount increases as you get older.
4. Other Expenses After Age 65: Once you turn 65, you can use your HSA for nonqualified medical expenses, such as purchasing a boat. However, these distributions will be subject to state and federal taxes, reducing the tax benefits of the HSA.

5. Incorporate HSAs into Your Estate Plan

In the event that your medical expenses are significantly lower than average or your lifespan is shorter than anticipated, you may have remaining funds in your HSA that can be transferred to your heirs. The regulations surrounding this process are intricate, so it is advisable to consult with an estate planning attorney. Generally, there are three categories to consider regarding how HSA assets are treated upon your death:

1. Spouse as Beneficiary: If your spouse is the designated beneficiary, the HSA is treated as their own, and they can use the funds according to the existing HSA rules.
2. Non-Spouse Beneficiary: If a non-spouse is the beneficiary, the HSA’s fair market value becomes taxable income to the beneficiary in the year of your death. The beneficiary may also use the HSA to pay for any of your qualified medical expenses incurred before your death within one year after your death, which would reduce the taxable amount.
3. Estate as Beneficiary: If your estate is the beneficiary, the HSA value is included in your final income tax return and becomes part of your estate. This may result in a higher tax liability depending on the estate’s total value and applicable tax laws.

Among the three options, many people prefer to name the surviving spouse as the designated beneficiary of an HSA. If there is no surviving spouse, it is important to consider tax efficiency when naming a beneficiary. In such cases, consider designating the party in the lowest tax bracket, whether that be your estate or another beneficiary. Collaborate with your tax and estate planning professionals to determine the most suitable option for your specific situation.

Plan ahead

Once you reach age 73, you are generally required to take minimum distributions from traditional IRAs and 401(k)s, which are subject to taxes. However, HSAs do not have any required minimum distributions.

Given the triple-tax advantage of an HSA, it is a valuable option to consider prioritizing to strengthen your retirement savings now and in the future.

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