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A Health Savings Account (HSA) can be a powerful tool to help you save for current health care expenses as well as health care costs during retirement.
According to Fidelity Investments, health care costs through retirement for couples retiring this year are now $245,000 -- up 29% since 2005. This estimate doesn't even include the cost of long-term care.
Most people are familiar with tax-preferred savings accounts like Individual Retirement Accounts (IRAs) and 401(k)s. Both accounts give tax breaks to help you grow money for retirement. Of course, another important financial concern of retirement is rising health care costs. And this is where a HSA account comes into play.
What is a Health Savings Account?
A HSA is a tax-exempt custodial account that can be set up to pay for medical expenses.
Unlike a Flexible Spending Account (FSA), your HSA funds will roll over year after year. Depending on where you set up the account, you can keep it in cash in the account or invest it in mutual funds or other investments.
HSAs offer you several important tax advantages:
- Contributions are tax deductible.
- Earnings and interest grow tax-free.
- Withdraw money tax-free for qualifying medical expenses.
- You will not find these triple tax breaks with any other account as every other retirement account taxes money when you take it out (traditional IRAs and 401(k)s) or when you put money in (Roth IRA).
- You can withdraw money for any purpose without penalty at age 65. This can be important if your HSA balance grows larger than you need to cover medical costs. While you will need to pay income tax on the withdrawals, this is similar to withdrawals from a traditional IRA or 401(k).
- Depending on your HSA provider, you can invest the money as you would with an IRA.
Why Your HSA is a Great Retirement Tool
Medical expenses are one of the greatest and most unpredictable retirement costs. HSAs benefit retirees in many ways. Virtually all medical expenses you incur during retirement can be paid for with HSA funds which means you will not owe taxes on withdraws. This means all growth in your account will be tax-free, assuming you only use the money for medical costs.
Health savings accounts offer more tax benefits than 401(k)s and IRAs when they are used to cover medical costs, a major retirement expense for most people. As with a traditional retirement account, a HSA allows you to set aside pre-tax money without paying state or federal income taxes. If you contribute through payroll deductions, you can also save the 7.65% FICA tax.The money in your HSA will grow tax-free. If it's used for medical expenses, it can also be withdrawn tax-free. An IRA or 401(k), on the other hand, imposes income tax when you withdraw money.
Even better, money that isn't used for current medical expenses will remain in the account and compound over time. You also have the option of withdrawing funds during retirement (at the age of 65 or Medicare eligibility) for non-health care purposes without penalty, but this will incur income taxes. These taxes are the same as if you had a traditional IRA or 401(k), so it's hardly a hardship.
How to Start Saving with a HSA
To qualify, you need to be covered by a high deductible health care plan, most of which have lower monthly premiums with high annual deductibles. (For 2016, the minimum deductible for an HSA-qualified health plan is $2,600 for a family or $1,300 for an individual.)
According to a report from the Employee Benefit Research Institute, about 17 million people had an HSA-eligible health insurance plan in 2014, yet just 13.8 million had an HSA.
Because employers save on premiums by offering high deductible plans to employees, many contribute to an employee HSA as an incentive. You can contribute up to $3,250 per year as an individual or $6,450 as a family. There is also a catch-up provision that allows people aged 55 and older to contribute an extra $1,000 per year.
Many companies offer health savings plans. Choosing the right one for you will depend on how you use the account. Shop around for a health savings account with banks, insurance companies, credit unions and HS custodians or administrators and be sure to compare fees and policies.
Some factors to consider:
- Convenience. Some HSA custodians have a network of ATMs and branches while others operate completely online.
- Access. While most HSAs now offer debit cards or checks, it's important to check how you will be able to access your funds.
- Fees. Check if the HSA will have a monthly fee, per-transaction charge, or other fees. Some HSAs have fees for just about everything, including to open your account, transfer money to an investment account, and "behavioral fees" that can be triggered by overdrafts.
- Investment options. If you want to invest the money to maximize your retirement savings, make sure you check the investment options offered by the HSA custodian. Some HSAs allow you to invest in mutual funds, stocks, and bonds, for example.
- Minimum balance requirements. While most HSAs do not require a minimum balance, some charge fees if your balance falls below $2,000 or $3,000.
Maximize Your Retirement Savings
Your HSA can be a great way to supplement your retirement, even if you have maxed out traditional retirement plan contributions for the year.
And the sooner you start and begin funding your HSA, the more your balance can compound over time. Just remember: once you enroll in Medicare, you are no longer eligible to contribute to your HSA, but you can continue using the balance for medical expenses.
With your HSA, you can invest your account in a diversified bond and stock portfolio to maximize your return. Assuming (1) you open a no-fee self-only HSA at the age of 21 and make the maximum contribution every year until retirement, (2) invest your contributions in the stock market and earn an average 8% return, you would have over $1.2 million in your account by retirement. If you're 40 and contribute just $100 per month until the age of 65 and get an average return of 3% a year, you would still have $45,000 by retirement age.
To fully leverage your retirement savings, it's a good idea to contribute money to both a HSA and traditional retirement account like an IRA or 401(k). Some financial experts recommend maxing out your IRA or 401(k) before making HSA contributions. This is because standard retirement accounts can be used for any retirement expenses while HSA accounts should only be used for medical expenses to avoid costs that reduce tax benefits. Also, it's important to take advantage of any 401(k) employer match, if your employer offers one, for the best return.
A common question among people with HSA retirement accounts is this: should you use the HSA for medical expenses that come up before retirement, or should you pay them out-of-pocket to allow the HSA funds to grow? This really depends on your preferences. Using your HSA now will help you save money on current medical expenses, but it can make it harder for the fund to grow over the next few decades. You will need to ask yourself whether it's better to spend more money today on medical expenses or have more money in a tax-free account that prepares you for retirement.
It's important to note that some people don't actually use their HSA to cover current medical expenses. Instead, they save their medical receipts for years, filing for reimbursement from the account after they retire for tax-free withdrawals that can supplement their income without tapping into accounts like IRAs and 401(k)s that could put them in a higher tax bracket. This strategy works because you can withdraw HSA funds tax-free for medical expenses at any point, even for expenses that occurred ears ago. While this may be a sound strategy, be sure you keep good records.
The Bottom Line
Health savings accounts are largely overlooked as retirement tools, but their triple tax benefits make them a great way to save, invest, and withdraw your money without taxes or penalties. If you already have a high deductible health plan or you think one could work for your current situation, it's worth it to open an HSA and begin making contributions.