Health savings accounts, otherwise known as HSAs, can be one of the key components of a retirement savings strategy and an overall financial plan for people who have higher deductible health care plans at work.
The overlooked value in HSAs comes from the preferential tax treatment of contributions to and withdrawals from the HSA that I believe often are superior to other savings vehicles, including Roth IRAs and 401(k)s. Let me explain why, starting with more background on how HSAs work.
HSAs began in 2004 and have been gaining steam in recent years as more people are selecting workplace health plans with higher deductibles. According to a study by the Employee Benefits Research Institute there were 22.2 million HSA accounts at the end of 2017, with 73% of those opened since 2014.
How most people use HSAs
According to the EBRI study, many people use their HSAs for tax-deferred savings to pay for current medical expenses. To the credit of many who use their HSA account, 95% of accounts ended 2017 with funds to roll over for future expenses.
However, only 13% of account holders contributed the fully allowable annual amount. Most account holders (96%) invested account balances in cash rather than long-term investments thus emphasizing that balances accumulated in the accounts are viewed as short-term buckets of available cash for expenses rather than a long-term savings strategy.
Tax treatment of HSAs
HSA contributions are considered to be made pre-tax, thus reducing federal and state tax liability. The contributions also are not subject to FICA taxes. Generally, contributions an employer makes to an account are not counted as part of taxable income. This can be similar to a company 401(k) plan. HSA accounts can grow tax-free in a similar way as traditional IRAs, Roth IRAs, 401(k)s; therefore, for some, investing their HSA balance in long-term investments can be an important strategy for maximizing the long-term positive impact to their life, which the EBRI study reflects is used by only 4% of account holders.
How HSAs compare to other retirement investment vehicles
The important component of HSAs that can make them superior, for some, to other vehicles is that withdrawals for qualified medical expenses are tax-free.
Withdrawals from traditional IRAs or 401(k)s often is a taxable event that should be properly planned for in retirement. Roth IRA distributions after retirement are not taxed, but contributions to the account came after that income was taxed. Please be aware, a withdrawal from a Roth 401(k) prior to age 59½ often is considered a taxable event.
In addition, unlike an IRA or 401(k), which are subject to Required Minimum Distributions after age 70½, HSAs do not require an owner to begin withdrawing funds at a certain age.
One drawback might be that HSA contributions are not allowed after age 65, and funds withdrawn before age 65 and not spent on qualified medical expenses will be subject to a 20% penalty plus income tax on the withdrawn amount.
After age 65, the 20% penalty goes away and the amount withdrawn is subject to ordinary income tax if not used for qualified medical expenses much like a 401(k) or traditional IRA.
Many people incorrectly assume Medicare will pay for all their health expenses after age 65, and therefore do not plan for additional medical costs to be part of their budget in retirement. According to a separate EBRI study, a married couple with median drug expenses will need $265,000 to have a 90% chance of paying retirement health costs such as deductibles, premiums, co-pays or co-insurance. Health expenses can be a significant part of the spending needs of a retiree.
A long-term health savings account strategy is not a replacement for traditional IRAs, Roth IRAs or 401(k)s, but it can be a significant component of a well-structured retirement income strategy within a financial plan. A strategy to balance contributions between various savings vehicles could reap significant tax benefits during retirement. Does your financial plan address this strategy?
Employee Benefit Research Institute, Issue Brief Summary, Oct. 15, 2018, tinyurl.com/y5b3ts67.
Employee Benefit Research Institute, January 2017, Volume 38, No. 1,Savings Medicare Beneficiaries Need for Health Expenses: Some Couples Could Need as Much as $350,000, tinyurl.com/yxtmwk4e
This information is being provided only as a general source of information and is not intended to be the primary basis for investment decisions. It should not be construed as advice designed to meet the particular needs of an individual investor. Please seek the advice of a financial adviser regarding your particular financial concerns. Consult with your tax adviser or attorney regarding specific tax issues.
The views expressed here reflect the views of Timothy Breitfelder as of Aug. 5, 2019. These views might change as market or other conditions change. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances.