The Underused Retirement Planning Power of Health Savings Accounts

The most powerful retirement planning tool probably is the health savings account (HSA), but many people fail to take full advantage of its benefits.

Use of HSAs is soaring. In 2022, there were more than 32 million HSAs holding about $100 billion, according to an estimate from Devenir, a firm that offers investment services to health-based accounts. The number of accounts increased by about 8% each of the last few years.

Anyone whose medical insurance qualifies as a high-deductible plan can have an HSA. Check with your insurer or employer to be sure you are HSA-eligible.

Any person can make contributions to your HSA, as long as the total contributions don’t exceed the annual limit. Employers often make contributions, as do individuals who own the accounts.

The maximum HSA contribution in 2024 is $4,150 for individual coverage and $8,300 for family coverage. An additional $1,000 catch-up contribution is allowed for those ages 55 and over. Contributions can’t be made once you sign up for Medicare.

Contributions made by an individual to his or her account are deductible from gross income, and contributions made by an employer to the employee’s account are excluded from gross income.

In addition, the account can be invested, and the earnings are tax free.

Distributions from the account are tax-free when used to pay for qualified medical expenses. A qualified medical expense is one that would be deductible as an itemized medical expense on your income tax return and that isn’t reimbursed by insurance or another source.

That’s three tax benefits, which makes the HSA unique. Unlike traditional 401(k)s and IRAs, you aren’t simply deferring taxes. Unlike with a Roth account, you aren’t paying taxes now to avoid taxes later. Money contributed to an HSA is never taxed, as long as distributions pay for or reimburse you for qualified medical expenses.

HSAs don’t have required minimum distributions during your lifetime. Your spouse can inherit your HSA and have the same benefits as you.

Most people use their HSAs during their working years to pay for medical expenses not paid by insurance, such as deductibles, copayments and noncovered costs.

But a better strategy is to fully fund and invest the HSA during your working years. Pay current medical expenses from non-HSA sources to the extent you can. Let the HSA balance compound for retirement.

Many HSAs can be linked to brokerage accounts to be invested like the rest of your retirement portfolio.

Of course, during retirement you can use the HSA to pay qualified medical expenses, including Medicare premiums and expenses that generally aren’t covered by Medicare, such as dental and vision services and hearing aids.

The expenses don’t have to be paid directly by the HSA. You can be reimbursed by the HSA after you pay the expenses. Keep receipts and proof of payment in case the IRS audits you or the HSA custodian raises questions.

Those distributions from the HSA are tax free because they pay for qualified medical expenses. They also won’t be included in modified adjusted gross income when computing the Medicare premium surtax, the amount of Social Security benefits to be taxed, or any of the other Stealth Taxes.

But an HSA can be used more effectively. You can use it to manage your tax bracket during retirement and to reduce your lifetime income taxes.

A key rule about HSAs is there’s no closing date for receiving reimbursement of medical expenses. A distribution doesn’t have to pay for current medical expenses to be tax free. You can accumulate receipts of qualified medical expenses that you paid from non-HSA sources in the past and take reimbursements from the HSA when you need tax-free spending money.

In a retirement year when you need additional cash, you don’t have to take it from taxable sources such as a traditional IRA or by selling assets in a taxable account for capital gains. Instead, take a tax-free reimbursement from the HSA for qualified medical expenses you paid in the past.

The strategy allows you to raise additional cash without increasing your tax bill for the year. The strategy is especially advantageous in a year when your income already is near the top of your tax bracket, or you want to avoid increasing the Medicare premium surtax or the amount of Social Security benefits that are taxed.

Some people don’t maximize contributions to an HSA while they’re working because they believe their out-of-pocket medical expenses won’t be high enough to exhaust the account balance and are concerned that they’ll have limited future access to the money.

Don’t worry about that. HSA distributions can be used to pay for nonmedical expenses. When distributions from an HSA are used to pay for anything other than qualified medical expenses, the distribution is included in gross income and taxed.

There’s an additional 20% penalty when you’re under age 65 and take a distribution for non-medical expenses. But beginning at age 65, a distribution from an HSA to pay non-medical expenses is taxed the same as a distribution from a traditional IRA.

An HSA also can be a legacy vehicle, passing tax-favored benefits to a spouse or other beneficiaries, as I explain in the next article.

I recommend that anyone who’s eligible for an HSA make maximum contributions to the account. It is often best to fully fund an HSA before contributing to a 401(k) or IRA. Invest the HSA the same as the rest of your retirement portfolio. The strategy will maximize the life of your retirement nest egg.