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How Can I Prepare for Healthcare Costs in Retirement?

Joe DowlingSeptember 15, 2016

Retirement Planning

Clients have become increasingly concerned about rising healthcare costs, both current and projected. Solutions for funding these costs have become an important part of client engagement and the financial planning process, and understandably so.

According to the Employee Benefit Research Institute (EBRI): “In 2015, a 65-year-old man needs $68,000 in savings and a 65-year-old woman needs $89,000 if each has a goal of having a 50 percent chance of having enough money saved to cover health care expenses in retirement. If either, instead, wants a 90 percent chance of having enough savings, $124,000 is needed for a man and $140,000 is needed for a woman. This analysis does not factor in the savings needed to cover long-term care expenses.”

So how can a couple go about saving and earmarking over a quarter of a million dollars to cover out-of-pocket healthcare costs in retirement? The most effective way is by taking action early and opening a Health Savings Account (HSA), established as part of the Medicare Prescription Drug, Improvement and Modernization Act, signed into law in December, 2003.

Although HSAs have been available for well over a decade, adoption rates have only begun to accelerate in recent years. This is likely due to the individual mandate to have insurance put the Affordable Care Act in full effect in 2014.  To counter the rise in healthcare premiums and cost, many employers  are transitioning their healthcare programs to Consumer Driven Healthcare Plans (CDHP), or High Deductible Healthcare Plans (HDHP). This has been crucial to the growth of HSAs, which can only be opened in tandem with eligible HDHPs. HSA assets topped $20 billion for the first time in 2014, and are projected to grow to over $54 billion by the end of 2018.

As healthcare consumers become more educated about the benefits of HSAs, growth of this market will continue to accelerate. The HDHP/HSA combination allows healthcare consumers to be more in control of their cash flow now,  rather than trading premium dollars with insurance companies, while providing a mechanism to build an asset bucket specifically allotted for healthcare costs in retirement.

What are some of the benefits of an HSA?

HSAs are triple tax free: 

  1. Contributions are pre-tax, so they reduce taxable income. Additionally, HSA contributions made via a traditional IRS Section 125 cafeteria plan by salary reduction are treated as employer contributions and not subject to the FICA payroll tax, enhancing the tax-efficiency for both the employee and the employer. Traditional 401(K) and Roth plan contributions are not exempt from the FICA tax.
  2. Distributions to pay for qualified medical expenses are tax free. In addition to standard diagnosis, cure, mitigation, treatment, or preventive medical services, qualified medical expenses include, but are not limited to, dental treatments, eye exams, eye glasses, hearing aids, Medicare insurance premiums, qualified long-term care services, and qualified long-term care insurance premiums (especially important as 7 out of 10 individuals over age 65 will need long term care at some point during retirement, according to a Nationwide Retirement Institute study). **For a full listing of qualified medical expenses, see IRS Publication 502 (https://www.irs.gov/pub/irs-pdf/p502.pdf)
  3. Invested HSA funds grow tax deferred, much like an IRA. A prudent approach is to accumulate enough money in a savings account equal to the annual out-of-pocket medical deductible. Funds above and beyond this threshold can be invested to take advantage of the tax-deferred growth feature.

Also, after age 65, HSA funds can be withdrawn penalty-free to pay for non-medical expenses. However, such a withdrawal is subject to ordinary income tax.

How much can be contributed to an HSA?

In 2016, contributions are limited to $3,350 for an individual and $6,750 for families (up from $6,650 in 2015). Also, similar to the catch-up provision commonly associated with 401(k) s and IRAs, an additional $1,000 can be contributed by those 55 and older. Effectively, a married couple 55 or older with kids can contribute almost $8,000 annually to an HSA, maximizing the tax efficiency described earlier.  Expectations are these contribution limits will rise along with  increases in healthcare costs.

HSAs are portable, meaning they can be moved to another provider when changing jobs.  Funds in the account never expire, which is not the case with Flexible Spending Accounts. Account holders do not need to “spend it, or lose it.” Also, HSA accounts can be transferred to a spouse or other beneficiary upon death.

HSAs provide a lot of flexibility to account holders, and are becoming as much of a retirement savings vehicle as a health care funding tool. HSAs will continue to become an important component of financial plans for individuals and couples, offering peace of mind to those concerned about paying for healthcare in retirement. Please contact our office if you wish to learn more or discuss your HSA options.

Sources

IRS Medical & Dental Expenses
Wikipedia – Health Savings Account
Schwab – The Surprising Advantage of Your HSA
Employee Benefit Research Institute
Health Reform Implementation Timeline
Devenir Research
Nationwide – Health Care in Retirement