As people start thinking about saving for retirement, they generally consider investing through a 401(k) plan or an individual retirement account (IRA). However, there are several other retirement plan options to choose from, many of which are frequently overlooked despite their utility. One is the health savings account (HSA).
While most people think of an HSA as a means of saving for health costs not covered by health plans, with some planning, an HSA can provide an incredible number of benefits during retirement.
What Exactly Is an HSA?
An HSA is a tax-advantaged account that was introduced as a way to help people with high-deductible health plans cover out-of-pocket costs. This account has been available since 2004, but not many people have taken advantage of it even though they may qualify, which involves having a high-deductible health plan through an employer.
An HSA can function as a sort of savings account for health expenses. Using this account over a traditional one is beneficial due to the tax advantages. However, you can make the most of the account by investing money in it and allowing it to grow over time, in effect saving for retirement.
You can make contributions to an HSA through pre-tax payroll deductions or from your own money. In the latter case, you can deduct the contributions from your taxes even if you choose not to itemize. Any contributions made by an employer are not counted as taxable income. Then, the account balance grows without any tax implications, meaning capital gains, dividends, and interest simply accrue over time. Finally, withdrawals for qualified medical expenses incur no taxes, which means that the HSA can be more beneficial than even a 401(k) or an IRA, especially if you know you will have significant health expenses in retirement.
An HSA has no required minimum distributions and the balance carries over from year to year. Also, you own the account, not your employer, so you can carry it between jobs.
How Does an HSA Work as a Retirement Account?
Those who want to use an HSA to save for retirement should primarily view it as an investment tool rather than a savings account. In other words, you should avoid spending your contributions if you can still afford to pay for medical bills without touching the account. You will get the most out of the account when you leave it untouched, much like a 401(k) or IRA.
Before age 65, any money withdrawn should be used for qualified medical expenses, otherwise, you will face a 20 percent penalty. After 65, you pay taxes on any money not used for qualified expenses, as with a 401(k) or IRA. You should also max out your contributions as much as possible. Currently, the maximum is $3,550 annually for an individual or $7,100 for a family. At 55, individuals are allowed an additional $1,000 annually in catch-up contributions.
With money in the account going untouched, the next step is to invest wisely. The investment strategy should mirror that of other retirement accounts, with consideration given to risk profile and diversification.
HSAs are not as restrictive as 401(k)s and look more like IRAs in terms of investment possibilities. You should be able to find a high-quality, low-cost plan with solid investments like respected mutual funds. Then, the money can simply grow over time.
The potential for growth is astounding. Imagine you begin putting the maximum contribution into the account each year starting at age 21 until you turn 65. Assuming an average annual return of about 8 percent, you would have well over $1.2 million by the time you retire.
The savings are impressive even with a more conservative scenario. If you are 40 and put only $100 per month in the account until reaching age 65, with an average annual return of 3 percent, you would have nearly $45,000.
How Can You Make the Most of an HSA?
Distributions from HSAs are not taxed if they are used for qualified medical expenses, so the money should be used for these purposes as much as possible, even in retirement. Since there are no required minimum distributions, it is feasible to mostly use this money for those expenses. As mentioned above, a 20 percent penalty is levied for using the funds for non-qualified expenses before age 65, but afterward, the money is simply subject to normal income tax. Generally, you should wait as long as possible to spend HSA assets to maximize their potential returns. Also, you should think about market fluctuations when considering taking a distribution. Selling at a loss should be avoided, if possible.
You should also make sure you designate a beneficiary for the account in the event of your death. Spouses can inherit the money without paying any taxes on the amount, but other individuals will need to. You can fill out a form with your plan administrator to designate a beneficiary. The choice should be revisited regularly as your situation changes.