Everyone knows about 401(k) plans and IRAs, but those with a high-deductible health plan (HDHP) have another option for building savings for retirement: the Health Savings Account (HSA).
Some employers that provide high-deductible health plans for their employees offer HSAs as well. More generous employers will even match your contributions or make direct contributions to your account even if you don’t.
If you don’t get an HSA from your employer, HSAs are offered by many financial institutions. This tool can help you find the best HSA provider for you.
Key Health Savings Account Benefits
Health savings accounts offer three big tax benefits:
- Contributions to an HSA 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 2021, you can contribute up to $3,600 if you’re single (or up to $7,200 for families). If you’re 55 or older, you can put in another $1,000.
Additionally, you can be reimbursed by your HSA for out-of-pocket expenses from previous years as long as the HSA was already established when the expenses were incurred – just be sure to save your receipts! Let’s say you opened your HSA in 2007 and paid out of pocket that year for a medical procedure. Now, in 2019, you can receive reimbursement for it from your HSA if you submit a claim with the receipt.
HSA 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 give some thought to your investment strategy in your HSA. Most HSAs offer a menu of mutual funds or exchange traded funds (ETFs) in which you may invest. You should 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 are able to use their HSA to pay for Medicare deductibles, prescription copays, and long-term care insurance premiums. That last one is particularly important since Medicare doesn’t cover long-term care.
That’s why some financial advisors say that HSAs should be a major 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 that 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 its needed, even if that’s decades from now. The more money you have in your HSA when you begin taking Social Security and are no longer able to contribute, the longer you won’t have to pay out-of-pocket for your healthcare expenses in retirement.
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Key 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 co-pays 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 also use your HSA to pay for certain insurance premiums. These include COBRA premiums, long-term care insurance premiums, and, if you’re 65 or older, Medicare. However, Medigap premiums are NOT eligible expenses.
2. Being Penalized Through Retroactive Social Security enrollment
If you wait until you reach full retirement age to claim your Social Security benefit, you’ll be given a choice to receive a lump sum of retroactive benefit that dates back six months.
But wait! If you choose to take that lump sum, that means you also have chosen to sign up for Medicare retroactively. And that may be a problem if you’ve been making regular HSA contributions–because you can’t do both. Contributing to your HSA while enrolled in Medicare leads to excess contributions.
If this happens, you’ll need to withdraw the amount of excess contribution 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 HSA 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.
Tax Considerations for California and New Jersey Residents
The benefits of HSAs are reduced for residents of California and New Jersey because both states treat HSAs as taxable accounts.
In both states, people who have their own HSA (in other words, not 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 have to pay taxes on those contributions as well. 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 in order to report them on your tax return. This can get complicated and requires organization and attention to detail.
To make things simpler, 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 manually calculate earnings and capital gains at tax time.
Another idea is to allow all interest and dividend income to accrue as throughout the year instead of reinvesting automatically. You can then reinvest that cash in the following year.
How to Get Started
If you’re not yet retired 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.