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An Overlooked Vehicle for Retirement Savings

On May 2nd, Phil Gagliardi wrote a blog that highlighted Health Savings Accounts (HSA) and how they can be used as a retirement strategy. He wanted to follow that up with an article that he found on Morningstar that continues to discuss this opportunity in much more detail. As always, this article covers the highlights of this subject and should not be construed as tax advice. For more information or if you would like to discuss further, please contact our office (610-651-2777).

 

Health-savings accounts are the only triple tax-advantaged vehicle in the tax code.

MORNINGSTAR/By Christine Benz | 08-18-14

You’ve crunched the numbers and determined that in order to retire on schedule, you’ve got to kick up your retirement-plan contributions. So, you’ve dutifully been making the maximum allowable company retirement plan and IRA deposits, and you’ve even begun saving for retirement in your taxable brokerage account.

But there’s one retirement wrapper that you may be neglecting: a health savings account (HSA).

True, HSAs aren’t specifically designed as retirement savings vehicles. Rather, their ostensible function is to cover the higher out-of-pocket costs that accompany being covered by a high-deductible health-care plan rather than a traditional health-care plan. But for people with limited ongoing medical expenses, an HSA can be a great piggy bank for additional retirement savings. And the tax benefits of HSAs are so generous that even people with more significant health-care costs might consider paying those expenses out of pocket, provided they can afford to do so, allowing the money can continue to compound in the HSA.

Many workers have the option to choose a traditional health-insurance plan through their employer, such as a PPO, or the high-deductible health-care plan/HSA combination. Opting for traditional insurance may seem more appealing because of its familiarity and its lower out-of-pocket costs. But the tax benefits of HSAs, which are only available to those who are covered by a high-deductible health-care plan, are such that individuals should revisit that decision–especially if they’re already taking advantage of other retirement-savings options like IRAs and 401(k)s.

Alphabet Soup Confusion

Before discussing the merits of HSAs as a retirement-savings vehicle, let’s first clear up a few common points of confusion about the accounts. People often mix up HSAs with FSAs, or flexible spending accounts, and there are some similarities. But there are key differences, too.

With both account types, you don’t pay taxes on the money going into the account, and the money isn’t taxable on the way out, either, provided it’s being used for qualified health-care expenditures. Both account types cover a wide range of expenses, including deductibles and copayments, but the funds are not usable for insurance premiums in most instances unless you’re over age 65.

However, the limit on FSA contributions is lower than is the case for HSAs. For 2014, the HSA contribution limit is $3,300 for individuals with self-only coverage through a high-deductible health-care plan and $6,550 for those with family coverage. People over age 55 can contribute an additional $1,000 to an HSA for 2014 (similar to an IRA catch-up contribution). Meanwhile, the contribution limit is $2,500 for FSAs, and there are no catch-up contributions for people over 55.

The major difference between HSAs and FSAs, however, is that HSA owners have much more of an opportunity for their assets to grow over time. Flexible spending accounts are no longer strictly “use it or lose it” as they were in the past; before the IRS changed the rules in late 2013, FSA funds not used by year-end would be forfeited. But FSA-account owners can only roll over $500 of their unused balances from one year to the next.

By contrast, there’s no limit on the amount of unused HSA funds that can roll over from one year to the next. Moreover, HSA assets can be invested in stocks and bonds, whereas monies in an FSA do not compound.

Yes, You Will Need the Money (But It’s OK if You Don’t)

Some investors considering an HSA as an additional retirement-savings vehicle may be put off by the fact that there are strictures on health-care expenses. The only way to obtain the triple tax benefit that HSAs afford–pretax contributions, tax-free compounding, and tax-free withdrawals–is to use the proceeds to cover health-care costs.

But being realistic about the out-of-pocket health-care costs you’re apt to face in retirement can help you get over that hurdle in a hurry. Fidelity’s most recent data suggest that the average couple will spend more than $220,000 on out-of-pocket health-care costs during retirement, including prescription drugs, Medicare premiums, and supplemental-insurance premiums. (While insurance premiums aren’t typically a qualified expenditure for HSAs prior to age 65, they do qualify for people who are over age 65.)

And just as notable is what Fidelity’s estimate excludes: long-term care costs. If an individual ends up needing long-term care, it’s realistic to expect costs of more than $75,000 per year, and even more for people who live in large urban centers. That’s one of the reasons I’m bullish on the HSA as the right wrapper for individuals who, due to their own choice or a lack of insurability, have decided to self-fund long-term care.

So high is the typical health-care outlay during retirement that a recent study from the Employee Benefits Research Institute suggested that individuals fully funding and investing their HSAs for 20 years would have between $118,000 and $193,000 (depending on the rate of return for the investments), which is below Fidelity’s estimate of $220,000 in in-retirement health-care costs for the average couple.

It’s also worth noting that at age 65, HSA investors can pull out their funds and use the proceeds on anything they like. The tax treatment isn’t as favorable as it would be if the distributions were used for qualified health-care expenditures, but it’s still decent. In fact, it’s akin to the tax treatment of assets in a traditional 401(k) or deductible traditional IRA: pretax contributions, tax-deferred compounding, and withdrawals taxed as ordinary income. From that standpoint, funding an HSA is on near-equal footing with funding a 401(k). (If you pull assets from an HSA prior to age 65 and don’t use them on qualified health-care expenses, you’ll owe both ordinary income taxes and a 20% penalty.)

You can (and should) also name a beneficiary for your HSA, so the assets can pass to your loved ones if you should die with money remaining in your account.

Which Account Type Gets Top Billing?

Even HSA true believers may find themselves stumped on a few items, though. Assuming they have a finite pool of assets to invest each year, which account type should you give priority: 401(k), IRA, or HSA?

I posed that question to investment advisor Rob Morrison, president of Huber Financial Advisors in Lincolnshire, Illinois. He believes that as a retirement-savings vehicle, an HSA should come after a 401(k) or IRA mainly because early HSA withdrawals come with more strings attached. “HSAs should be funded only after 401(k)s and IRAs in most cases because access to [HSA] funds for retirement is allowable at 65 versus 59 for 401(k)s and IRAs. And the penalty is higher (20% versus 10% for IRAs and 401(k)s) for any non-medical distributions prior to [those ages],” he said.

Financial advisor Allan Roth of Wealth Logic in Colorado Springs, Colorado, is of a similar mind, but thinks that savers might reasonably put an HSA further up in the funding queue under certain circumstances. “In practice, I use an HSA after all other tax-advantaged vehicles are maxed out, but there is an argument to use it even before. This is especially true if one has a lousy 401(k) with expensive options and no matching,” he said.

Should I Pay Out of Pocket Or Spend My HSA?

A related question is whether to use the funds from the HSA as you incur out-of-pocket health-care costs or, given the tax benefits, let the HSA assets grow.

The right answer depends primarily on how you’re doing on saving in your tax-sheltered accounts. If you’re already maxing out your contributions to an IRA and a 401(k), that argues for paying your health-care costs using non-HSA dollars, because you need to take advantage of all of the tax-sheltering retirement-savings vehicles you can.

But if you’re not maxing out your 401(k) and IRA contributions, you’re better off using your HSA assets to cover out-of-pocket health-care costs; that way, those health-care expenditures aren’t impeding your ability to contribute to other tax-sheltered retirement-savings vehicles.