Save for Retirement Medical Expenses in a Triple Tax-Free Way

Medical expenses are a primary concern when saving for retirement. You want to ensure that you have the financial resources for optimal health care in your senior years, and this is where a health savings account (HSA) comes into play. HSAs are the only savings and investment accounts that are literally triple tax-free: tax-deductible contributions, tax-free investment accumulation and tax-free withdrawals for qualified medical expenses. In this way they have an advantage over either a 401(k) or Roth IRA. Consider the HSA as a tool that can supplement your retirement income for future medical expenses. Given that Medicare “means testing,” or charging higher Medicare premiums for people with higher income, has already begun indicates that high-income people should be concerned about Medicare coverage in retirement and be better prepared to pay their own way.

According to the 2015 Retirement Health Care Costs Data Report by HealthView Insights, average lifetime health care expenses for a 55-year-old couple retiring in 10 years will amount to $463,849. This assumes that the life expectancy is 87 for men and 89 for women. In addition, the U.S. Department of the Actuary’s projection for health care inflation is around 6% for the next 10 years. What action can you take? Prepare for your future medical needs while you’re still working. An HSA can help you do that.

What Is an HSA?

A health savings account is an account that is triple tax-exempt and targeted toward people with a high-deductible health plan (HDHP). A health savings account can benefit high-income earners because it will allow you to save above and beyond what you are already contributing to your 401(k) or IRA. For an individual, the maximum annual HSA contribution limit is $3,350; for families, it is $6,750. A catch-up contribution of $1,000 a year is also available for those 55 years and older.

Withdrawals can be made from HSAs to reimburse out-of-pocket medical expenses in a high-deductible plan, but for future retirement benefits, current withdrawals should be limited or avoided in order for the investment balance to accumulate. This means that current medical expenses have to be paid from current income or other sources, which is another reason why HSAs are most suitable for high-income people and people who are generally healthy with few current medical expenses.

Who Is Qualified to Open an HSA?

According to the IRS, you are eligible to open an HSA if you are covered by an HDHP, which has a minimum deductible of $1,300 for individuals and $2,600 for families. You should neither be enrolled in Medicare nor have other health coverage except for a few exceptions permitted by the IRS. You also cannot be claimed by your spouse or another person as a dependent.

Why Get an HSA?

Health savings accounts have become increasingly attractive to high-income earners because of their triple tax benefits:

  • Tax-deductible contributions: Whether HSA contributions are deducted from your payroll using pretax dollars or made using post-tax dollars (you’ll receive a tax deduction), these contributions are tax-deductible.
  • Tax-free growth: The growth in earnings, interest and dividends is not taxable.
  • Tax-free withdrawals for qualified medical expenses: You can withdraw funds at any time without being taxed if you’re using the money for qualified medical expenses.

It’s important to note that if you withdraw funds for nonmedical reasons before you turn 65, you will be taxed for income and pay a 20% penalty. When you withdraw money after age 65 for nonmedical purposes, it will be taxed as income. That’s why an ideal approach for HSAs is to contribute money during your working years and let that money sit, withdrawing from your account after you’re retired and, ideally, for medical reasons only.

Finally, another advantage of an HSA is that it is “portable,” which means that even if you move to another company or stop working altogether, your account, along with its balance, stays with you. Simply put, your HSA is yours alone.

How Can an HSA Supplement Your Retirement Income?

First, if you are 55 and contribute to an HSA, you can potentially see a balance of $60,000 in 10 years, according to the Employee Benefits Research Institute. This assumes that you contribute the maximum amount permitted and that you earn a 5% rate of return. If you are 45 and maximize your contributions, you could have a balance of $150,000 by 65. You can use an HSA calculator to compute your possible future balance.

Second, if you withdraw from your HSA for medical reasons at any time, you won’t be taxed. Withdrawing for nonmedical reasons starting at age 65 subjects you to ordinary income tax just like your 401(k) and other retirement accounts. You won’t have to pay a penalty. You also have the option to keep the money growing and not use it. The longer you defer, the potentially higher the returns. Unlike other retirement accounts, you are not obliged to make required minimum distributions. You can let your money sit in the account, growing, and rest assured that you have a fund to tap into when you have medical expenses. You can also designate a beneficiary to inherit your HSA.

To supplement your retirement income, max out your contributions to your IRAs or other retirement accounts during your working years. Then max out your HSA and don’t withdraw from it until you’re retired. If you can’t afford to max out both, an alternative strategy may be slightly reducing your 401(k) or other retirement accounts and modestly funding an HSA. You might consider an HSA as a save-it-for-last account, using it for medical purposes in retirement and drawing on it for nonmedical expenses only if absolutely necessary.

We shouldn’t assume that Medicare will cover all of our medical care in retirement. If one takes into account the facts that health care inflation is above average and Medicare benefits may be limited for high-income people in the future, opting for a health savings account now as a safety net may be a wise decision.