Do You Have The Ultimate Retirement Account? Part 2
Happy Wednesday! This week’s post is a couple of days early and I will explain why below.
Last week’s post was a bit of a teaser. We talked about what the criteria would be for the ultimate retirement account. We established that it would have to be a triple tax advantaged account, which means tax free contributions, tax free growth, and tax free distributions.
Does such an account exist?
Cue grand entrance music . . . enter the Health Savings Account (HSA)!
What is an HSA?
An HSA, as the name applies, is a savings account that was designed to be a tax advantaged pass through account used for healthcare expenses. It was not designed to be a retirement account, but we’ll talk about that more in a bit.
There are strict criteria to have an HSA. In order to be eligible for an HSA, you must be enrolled in a high deductible health plan (HDHP) for your health insurance. For 2019, the IRS guidelines (IRS publication 969) for HSA eligibility state that the HDHP must have an annual deductible of at least $1,350 for self-coverage and $2,700 for family coverage. The IRS also specifies that the maximum annual deductible plus other out-of pocket expenses not exceed $6,750 for self-coverage and $13,500 for family coverage. (If some of these terms are unfamiliar, check out my post on The Top Ten Terms You Should Know About Health Insurance).
The money in an HSA can be used to pay for qualified medical expenses. This can be done with a debit card or checks that are issued when the account is opened. Alternatively, you can pay out of pocket for a qualified medical expense and then get reimbursed from the account so long as you have the documentation to prove it was a qualified medical expenses. The list of qualified medical expenses is quite long and comprehensive and also includes dental, vision, and hearing care expenses that are not typically covered by health insurance (listed here in IRS publication 502). However, it is important to note that HSA funds cannot be used to pay for health insurance premiums before age 65.
There are two components to an HSA: a cash component and an investment component. When money is contributed to the HSA, it is initially deposited into the cash portion of the account. You can then use that money to purchase investments, just like a 401(k), which would become the investment component of the account. If you use the HSA funds to pay for medical expenses it will typically come from the cash component of the account, so many HSAs require you keep a certain minimum amount of cash available, but the rest can be invested.
Another important feature of an HSA is that the money rolls over every year. Unlike a Flexible Spending Account (FSA), an HSA is not a “use it or lose it” type of account. There is no penalty for not spending the money in your HSA.
How Do I Open an HSA?
People typically open an HSA in one of two ways. First, many employers that offer HDHPs as a health insurance option also offer an HSA. This is what I do. My health insurance is a HDHP through Medica, which is now the the insurance company for employees of the Mayo Clinic, and my HSA is through Fidelity, who handles retirement accounts for Mayo Clinic employees.
The other common way people open an HSA is through a separate account on their own, so long as they have a qualifying HDHP. If you choose this route, be sure that your health insurance qualifies for an HSA per IRS guidelines and is “HSA-eligible.”
What Are The Tax Advantages?
Now that you have a basic understanding of what an HSA is, what are the tax advantages?
First, contributions to an HSA are made with pre-tax dollars (like a 401(k) or traditional IRA). If your HSA is through your employer, then your elected HSA contribution is deducted from your gross paycheck before any taxes are calculated and deducted. If you have a separate HSA outside of your employer, you can deduct your annual contributions from your taxable income come tax time. Given this tax benefit, the IRS limits the amount that can be contributed to an HSA each year. In 2019 the limit was $3,500 for individuals and $7,000 for families. In 2020 this increases to $3,550 and $7,100, respectively.
Second, the money in the investment component of the HSA grows tax free.
Third, if the money in the HSA is used to pay for, or reimburse for, qualified medical expenses, it can be withdrawn tax free.
These features are what make the HSA the only triple tax advantaged account available. Can you see the ultimate retirement account beginning to take shape?
But whenever there are tax advantages, there are also penalties if you don’t follow the rules. If you withdraw the money before age 65, you not only owe taxes on it, but there is also a 20% penalty. Ouch! However, if you withdraw the money after age 65 for anything that is not a medical expense, then you simply owe taxes on the amount distributed and there is no penalty. So in this way, after age 65 it acts just like a traditional IRA would for any distributions other than for qualified medical expenses.
But How Can an HSA be a Retirement Account?
OK, so now you understand what an HSA is and how it is a triple tax advantaged account. But it’s made for qualified health related expenses, right? So how can it be used as a retirement account?
Great question. Although it was not designed specifically to be a retirement account, for the financially savvy that is exactly how it can function, and here’s how.
Under the current IRS HSA rules, you are allowed to reimburse yourself from your HSA for qualified medical expenses incurred in previous years. This allowance can transform what appears to be a pass through tax advantaged account for medical expenses into the ultimate requirement account.
Here are the steps you must follow to take advantage of and maximize an HSA as the ultimate retirement account:
- Open an HSA and maximize the tax free contributions each year.
- Invest the money in the HSA with a long term growth strategy, like a low cost passive index fund, and allow the money to grow tax free.
- Pay for all medical expenses out of pocket; DO NOT use the funds within your HSA.
- Save all documentation and receipts for qualified medical expenses, planning for future reimbursement.
- In retirement, begin making tax free distributions from the account as reimbursement for the out of pocket qualified medical expenses in previous years for which you have saved the documentation. This money can then be spent on whatever you choose.
By following these simple steps, the HSA can literally become the ultimate retirement account.
The Nuts and Bolts of Our HSA Plan
Let’s look at a case study to better understand the details of this plan and how an HSA can function as the ultimate retirement account. We will use my family and me as an example.
Since I am in the highest tax bracket, and nearly half of everything I earn goes to taxes, I am always looking for ways to minimize my tax burden. So when I heard about using the HSA as a retirement account, I was all ears and learned everything I could about this strategy. In 2018 I made the switch to a HDHP and opened an HSA. Here are the specific steps that I took.
First, I switched our family’s health insurance during the open enrollment in 2018, so that in 2019 we would be in a HDHP. Next, I signed us up for an HSA through my employer with Fidelity, the same place my 403(b) and non-governmental 457(b) accounts are. Then, I elected to contribute the maximum amount of $7,000 in 2019 to my HSA. Remember, this is a tax free contribution, and since this is through my employer, it appears as a pre-tax deduction on my paycheck. Since I am paid biweekly, and there are 26 paychecks in the year, this works out to be $269.24 deducted from each paycheck.
The biweekly paycheck deductions are deposited into the cash account portion of our HSA. I have configured our account such that once $500 in cash was reached, all further contributions would be invested into low cost passive index funds. In line with our current 80/20 stock to bond asset allocation, 80% of our investments in this account are in the Fidelity 500 Index Fund (FXAIX) that tracks the S&P 500 index, and 20% in the Fidelity U.S. Bond Index Fund (FXNAX). In case you were wondering, these were what I thought were the best index funds available in our HSA. Unlike our 403(b), 457(b), and taxable brokerage accounts, Vanguard index funds were not available in our HSA. I’ve been happy with these Fidelity funds so far.
Now this money is growing tax free. At the end of the year we will have $500 in the cash portion of the account and $6,500, plus the earnings based on market performance, in the investment portion of the account. For next year we have already made the election during this year’s open enrollment period to contribute the maximum $7,100, which will again be divided among 26 paychecks. In 2020 the whole sum will go into the investment component of the account.
As outlined above, we are not spending the money in our HSA on our family’s current health care expenses. Any medical expenses have been paid for out of pocket. Fortunately, our family is blessed with good health and no one has any chronic conditions that are a major expense. As we approach the end of 2019, we are far below having paid our deductible and out of pocket maximum. During the last year some of the expenses we have had that will qualify for future reimbursement include dental work for multiple family members, one of my kids needed an eye exam and glasses, and I needed new contacts. We are saving the receipts for each of these expenses (both a paper and electronic version) for reimbursement in the future. Again, this allows the untouched money to grow tax free in the HSA allowing it to function as a retirement investment account.
We plan to continue this strategy year after year. Since I am currently 40 years old, under current IRS rules I am able to continue contributing to the HSA for the next 25 years until age 65. Let’s do a little future projection. Let’s say over the next 25 years the average amount we can contribute to our HSA will be $8,000, which I feel is a reasonable estimate since it seems to go up a little bit every year and we are already at $7,100. So if we contributed $8,000 to our HSA over the next 25 years until I am age 65 and our investments grow and compound at a rate of say 7%, we will have more than $500,000 in the account! At that point, we can used the saved receipts to reimburse ourselves for the previous qualified medical expenses in past years and spend the money on whatever we want, or we can use it to pay for any future qualified medical expenses. This is half a million dollars that was contributed tax free, grows tax free, and can be withdrawn tax free!
So when and how will we access the money? Excellent question. Currently there is no time period restriction on when you can reimburse yourself for qualified medical expenses. For example, in 2019 we paid out of pocket for some dental work above what our dental insurance covers, some prescription medications, a pair of glasses, and some contact lenses. We are saving all of the receipts for these qualified medical expenses. At any point in the future, even 30 years from now, we can withdraw the money from our HSA equal to these expenses and claim reimbursement so long as we have the receipts to prove it. This money then comes out tax free and we can use it for anything.
By following this strategy, you can transform the HSA into the ultimate triple tax advantaged retirement account. Let’s review. The money contributed is tax free. It grows tax free. And so long as you have documentation to prove it is reimbursement for a qualified medical expense, the money is distributed tax free.
Other Benefits of an HSA
As if this weren’t enough to make the HSA the ultimate retirement account, here are a few other awesome features.
- There are no income limits on contributions. Unlike a Roth IRA where the ability to make a direct contribution phases out with increasing annual income, it doesn’t matter how much your income is, anyone can contribute to an HSA, so long as they have a qualifying HDHP.
- There are higher annual contribution limits than a traditional or Roth IRA. In 2019 the maximum amount before age 50 that you could contribute to a traditional or Roth IRA was $6,000. Maximum HSA for a family was $7,000.
- Unlike like a traditional IRA, there are no required minimum distributions with an HSA. If your money is in a traditional IRA, at age 70 1/2 you are required to begin withdrawing money or you face a steep 50% penalty plus taxes. In this way, the government forces you to pay taxes on your retirement savings. These rules do not apply to an HSA.
- After age 65 an HSA can be used tax and penalty free to pay health care premiums, including Medicare part B and long term care insurance. While you can’t use an HSA before age 65 to pay for your health insurance, after age 65 you can, and paying for future healthcare is one of the major stresses of those in retirement.
These factors all combine to further bolster the HSA’s status as the ultimate retirement account.
Dangers and Concerns of This Strategy
Wait a minute, T.K., this sounds too good to be true. What’s the catch?
You’re right, there are some definite concerns about this strategy that I would like to review here.
What if you don’t have enough medical expenditures to reimburse for?
This is usually the first thing someone questions about this plan. Most people will not have spent more on qualified medical expenses than the amount that has grown in their HSA over many years. Even if our family spent $10,000 per year out-of pocket on qualified medical expenses for the next 25 years (which I certainly hope we don’t), this would still only total $250,000 which is less than half of the projected amount in the above example. So now what?
While an excellent question/concern, this strategy isn’t designed so that you have reimbursable receipts to cover your entire HSA balance. There are multiple ways to access the money in the HSA.
Of course, reimbursement for previous qualified medical expenses is the best because you can withdraw the money tax free and spend it on anything at that point.
The next best option is probably to spend it on what the HSA was originally designed for: medical expenses. Current studies estimate that a 65 year old HEALTHY couple retiring today will likely need to spend $300,000 to $400,000 on healthcare during their retirement, which is why this is a major fear for many couples reaching retirement age. The HSA can be used to cover most if not all of these expenses . . . tax free!
Finally, if there is still money beyond this in your HSA and you are over age 65, you can simply withdraw money and spend it on anything you want. You will have to pay the taxes on the amount withdrawn, but there will be no penalty. This allows it to function like a traditional IRA, but without the burden of RMDs.
What if the laws change for HSAs?
This is probably the biggest weakness of this plan. Currently a time limit does not exist for when you can be reimbursed for a qualified medical expense, which really allows this strategy to work. However, it is entirely feasible that the IRS could change the rules at any point and require you to request reimbursement for a qualified medical expense within the same tax year. That would basically make this plan as outlined impossible. If this were to happen, then what?
Well, as outlined above, there are multiple other uses for the HSA. If this were to happen I would plan to primarily use my HSA for healthcare related expenses in retirement, which again are projected to be more than $300,000 for the average healthy couple. This would not only cover a needed expense, but would still give you the triple tax advantage. Any other funds could be withdrawn after age 65 for non-medical expenses and taxes paid.
I think it is important to also point out that our HSA is only a small portion of our investment portfolio and overall retirement strategy. You should never place all of your eggs in one basket. Just as our investments are diversified, so are our retirement accounts and strategies to access this money in the future.
There is a steep penalty for non-medical withdrawals
If money is withdrawn from an HSA for something other than a qualified medical expense and before age 65, then taxes are due plus a 20% penalty. This is a harsh penalty and essentially negates any tax advantages of having this plan and then some. So before making this part of your retirement strategy, it is important to have other aspects of your financial house in order so you won’t ever need to withdraw funds from your HSA for non-medical expenses and face these penalties.
Don’t confuse an FSA for an HSA
Remember, a Flexible Spending Account (FSA) is NOT the same as a Health Savings Account (HSA). Many people confuse the two because both are tax advantaged accounts that can be used to pay for qualified medical expenses. However, an FSA does not have an investment component and must be spent every year or you lose it. If you are going to adopt any of the strategies discussed here, make sure you are getting an HSA, not an FSA.
Is An HSA for Everyone?
Enrolling in a HDHP, opening an HSA, and using it as a retirement account is an excellent strategy. However, it is not for everyone.
Who is it good for?
- Individuals and families without chronic health problems/expenses. It doesn’t make much sense to try and employ this strategy and enroll in a HDHP if you have to pay that entire high deductible year after year. Those in this situation would likely be better served in a health insurance plan with higher premiums and a lower deductible and out of pocket maximum.
- Those that can afford to pay for medical expenses out of pocket. A key part of this plan to use the HSA as a retirement account is that you pay for your medical expenses out of pocket and not tap into the HSA, allowing the power of compounding over time to take effect. If you do not have the funds to do this, then this likely isn’t the best strategy for you.
- Those with high incomes and in high tax brackets looking for more ways to decrease their overall tax burden and save for retirement.
Who is it not good for?
- Those with chronic health problems or recurring medical expenses that would result in having to pay the high deductible and out of pocket maximum of a HDHP.
- Those who have not paid off consumer and other high interest debt. Make that a focus first before embarking on some of these more advanced retirement strategies.
- Those who cannot afford to pay for medical expenses out of pocket.
If you are interested in making this a part of your financial and retirement plan, I strongly recommend you review it with your accountant, financial advisor, or other licensed professional. Remember, I am none of these things and just trying to share with you part of my personal financial strategy for your education, entertainment, and information, not as professional advice.
Conclusion
In summary, if used correctly, and under current IRS guidelines, the HSA can function as the ultimate retirement account.
The reason I posted this early is that right now many people are in the middle of open enrollment in their place of employment. Where I work, open enrollment ends on November 15th, so I wanted to give people a few days to think about this strategy before it ends in case they decided this made sense for them and wanted to make some changes.
With that, thanks for reading. I hope you found this information helpful as you continue on your own journey towards financial independence.
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