How a Health Savings Account Can Benefit Your Retirement Plan

Everyone knows about 401(k) plans and IRAs, but those with a high-deductible health plan (HDHP) have another option for building retirement savings: the Health Savings Account (HSA). These are tax-advantaged accounts that help people save money for future medical expenses.

Some employers that provide high-deductible health plans for their employees also offer HSAs. More generous employers will match your contributions or directly contribute to your account even if you don’t.

If you don’t get an HSA from your employer, many financial institutions offer them. This tool can help you find the best HSA provider for you.

Key Health Savings Account Benefits

Health savings accounts offer three significant tax advantages:

• Contributions to health savings accounts are tax-deferred like those of a pretax retirement account such as a 401(k), reducing your taxable income.
• Earnings on the investments in your HSA grow tax-free and are not subject to capital gains taxes.
• Withdrawals for qualified medical expenses are also tax-free.

In 2024, you can contribute up to $3,850 if you’re single (or up to $7,750 for families). If you’re 55 or older, you can put in another $1,000.

Additionally, you can use your HSA to reimburse yourself out-of-pocket medical expenses from previous years as long as the account was already established when the expenses were incurred – just be sure to save your receipts! Let’s say you opened your health savings account in 2007 and paid out of pocket for a health care procedure. Now, you can receive reimbursement from your HSA if you submit a claim with the receipt.

Health Savings Account Limitations and Restrictions

As is the case with other special-purpose savings vehicles, HSAs are subject to specific limitations.

First, if you take money out for non-qualified expenses, you’ll have to pay regular income tax on it. And if you’re under 65, you’ll also pay a 20% penalty.

Second, you may no longer contribute to your HSA after you begin collecting Social Security.

Third, you must consider your investment strategy in your HSA. Most HSAs offer a menu of mutual or exchange-traded funds (ETFs) where you may invest. It would help to consider your risk tolerance and time horizon when picking funds for your HSA.

What is the Benefit for Retirement?

In addition to out-of-pocket expenses, retirees can use their HSA to pay for Medicare deductibles, prescription copays, and long-term care insurance premiums. That last one is critical since Medicare doesn’t cover long-term care.

That’s why some financial advisors say HSAs should be a significant component of their clients’ retirement plans. A few even tell their clients to max out their HSAs each year before contributing to other accounts.

Pre-retirees in good health and those who can pay their current medical pills out-of-pocket stand to benefit the most from contributing to an HSA, as the money can sit in the account until it’s needed, even if that’s decades from now. The more money you have in your HSA when you begin taking Social Security and can no longer contribute, the longer you won’t have to pay out-of-pocket for your healthcare expenses in retirement.

Key Health Savings Account Mistakes to Avoid

If you’re nearing retirement, here are three things that you’ll want to avoid if you’re trying to maximize the benefits of an HSA:

1. Not Buying Insurance With Your HSA

Sure, you can use the funds in your HSA to pay for qualified medical expenses—think copays and vision and dental expenses— but if you use HSA funds to pay for qualified medical costs, you won’t be able to claim those costs as itemized deductions.

Instead, you can use your HSA to pay certain insurance premiums. These include COBRA premiums, long-term care insurance premiums, and Medicare if you’re 65 or older. However, Medigap premiums are NOT eligible expenses.

2. Incurring a Penalty Through Retroactive Social Security Enrollment

If you wait until you reach full retirement age to claim your Social Security benefit, you’ll be able to choose to receive a lump sum of retroactive benefit that dates back six months.

However, if you choose to take that lump sum, you have also decided to sign up for Medicare retroactively. That may be a problem if you’ve made regular HSA contributions because you can’t only do one. Contributing to a health savings account while enrolled in Medicare leads to excess contributions.

If this happens, you’ll need to withdraw the excess contributions you’ve made before Tax Day, and they will be included in your taxable income. OR you’ll pay a 6% excise tax for every tax year the excess contributions remain in your account. Ouch.

3. Using Your Health Savings Account to Pay for Non-Medical Expenses

If you withdraw money from your HSA for non-qualified medical expenses before you turn 65, be prepared to pony up 20% for the withdrawal penalty, which is more than the 10% early withdrawal penalty from IRAs and 401(k) plans. You’ll pay the penalty PLUS regular income taxes on the withdrawn amount.

If you’re over 65, you’ll still have to pay income taxes on non-qualified HSA withdrawals, but you won’t have to deal with the 20% penalty.

HSA Tax Considerations for California and New Jersey Residents

Health savings accounts (HSAs) are reduced in benefits for residents of California and New Jersey because both states treat HSAs as taxable accounts.

In both states, people with a health savings account (instead of one funded through their employer) may have to adjust their federal adjusted gross income (AGI) on their state tax return.

The news is worse for Californians. If an employer puts money in your HSA, you’ll also have to pay taxes on those contributions. Additionally, California treats investment earnings within an HSA as taxable as well. So, if you live in the Golden State, you’ll have to report all interest, dividends, and capital gains on investments earned in your HSA.

And here’s the clincher: you’ll need to track those numbers manually to report them on your tax return. This can get complicated and requires organization and attention to detail.

To simplify things, some experts suggest investing your HSA in a target date fund rather than actively trading between multiple investments. The fewer investments you own in your HSA (and the less frequently you buy and sell them), the easier it will be to calculate earnings and capital gains manually at tax time.

Another idea is to allow all interest and dividend income to accrue throughout the year instead of reinvesting automatically. You can then reinvest that cash in the following year.

How to Get Started

If you still need to retire and want to explore how an HSA can fit into your retirement plan and Social Security strategy, one of our advisors can help. Get started by requesting a free, no-obligation consultation today or browse our advisor directory to find one in your area.