Invest Retirement

How to Use an HSA to Boost Your Retirement Savings

Dayana Yochim  |  July 16, 2020

With rising healthcare costs and retirement savings uncertainty, a Health Savings Account (HSA) could save your retirement. Here are 5 HSA rules to know.

A Health Savings Account (HSA) is like a Swiss Army knife: It has tools to cut your current taxes, slice your medical costs and tighten the scaffolding on your retirement savings. The account’s main feature is that it lets you put aside pre-tax money to pay for healthcare expenses. But it can also serve as a tax-free, long-term investment account.

Put another way, if a Flexible Spending Account (FSA) and an Individual Retirement Account (IRA) had a love child, it’d look a lot like an HSA.

What is an HSA?

An HSA is an account you open at a bank or brokerage firm that gives you several tax breaks on money you set aside and use to pay for qualified medical expenses. You fund the account with pre-tax dollars. And when it’s time to pay for out-of-pocket healthcare-related costs — such deductibles, coinsurance, copays and prescriptions — your withdrawals are tax-free.

A 65-year-old woman retiring in 2019 can expect to spend $150,000 out-of-pocket on health-related expenses in retirement.

The most unique feature of an HSA is how it can be used as a tax-free, long-term investment account. Instead of sitting in cash, the money you contribute to the account can be invested in mutual funds, bonds, CDs and even stocks. The money grows tax-free until you need it, at which point qualified withdrawals are also tax-free.

Why you need an HSA

Healthcare is one of the biggest expenses in retirement. Just how big? According to Fidelity Investment’s annual Retiree Health Care Cost Estimate, a 65-year-old woman who retired in 2019 can expect to spend $150,000 out-of-pocket in health-related expenses in retirement. For couples, the number is $285,000, and single retired men face $135,000 in costs.

Having a pool of money earmarked for these expenses provides protection for the rest of your wealth. It means you won’t have to tap your IRAs and 401(k)s to pay for medical emergencies. Plus, unlike withdrawals from those accounts that are subject to ordinary income taxes, qualified distributions from an HSA (using the money for health-related expenses) are completely tax-free. 

If you don’t end up needing the money for healthcare, your HSA can serve as a backup nest egg. After your 65th birthday the IRS allows you to raid your HSA to spend on non-medical expenses without triggering a 20% early penalty. You don’t get off completely scot free: HSA rules still require you to pay ordinary income taxes on withdrawals just as you would with distributions from a traditional IRA or 401(k). Still, not a bad deal.

HSA vs. FSA

The FSA (Flexible Spending Account) is a close cousin to the HSA. Both accounts help you save money on medical expenses. Here’s what they have in common:

  • Contributions to both HSAs and FSAs are not taxed. If you fund an HSA or FSA through your employer, the money is taken out of your paycheck and deposited into the account before taxes are taken out. If you set up and contribute to an HSA on your own and not through an employer, your contributions are tax-deductible.
  • The government sets maximum limits on how much you’re allowed to save in HSAs and FSAs. 
  • The IRS requires you to spend HSA and FSA money on qualified out-of-pocket medical expenses. You’ll pay a penalty (and taxes) if you use the money on non-qualified items. 
  • Withdrawals to pay for qualified medical expenses are tax-free.

The main differences between HSAs and FSAs:

  • You can invest money in an HSA in different investments (mutual funds, CDs, bonds, even stocks). (Note: Not all HSAs offer investment options.) FSAs have no investment component. Your savings earns no interest. 
  • The FSA has “use it or lose it rules” — if you don’t spend the money in the account within the year, you forfeit it. You’ll never lose your money in an HSA. There are no “use-by” deadlines. According to HSA rules, you’re free to leave the money in the account as long as you’d like. The IRS doesn’t even require you to start taking required minimum distributions in retirement.  
  • Contributions to an FSA must take place during the calendar year (January through December). HSA contributions are allowed from January through the tax due date the following year. (E.g. You have until April 15, 2021 to fund your 2020 HSA.)
  • HSAs are portable, meaning if you leave your job, the account remains yours. If you leave your job before draining your FSA, you sacrifice any dollars left in the account. 

5 HSA Rules To Know

Here are the key HSA rules to know. (And here’s the in-depth, fine-print IRS version.)

1. You can only open one if you’re enrolled in a high-deductible health insurance plan

The IRS sets the rules on HSA eligibility. There are four main guidelines that determine if you can contribute to an HSA: 

  • You must be enrolled in a high-deductible health insurance plan (HDHP). For 2020 the IRS defines a HDHP as one with a deductible (the amount you pay before your plan starts to cover costs) that is at least $1,400 for an individual, and $2,800 if you have a family policy.
  • Additionally, your maximum annual out-of-pocket costs for your health plan cannot exceed $6,900 for individuals or $13,800 for families.
  • Your health insurance has to allow policyholders to open an HSA. Not all HDHPs allow policy holders to open an HSA.
  • You’re not allowed to fund your own HSA if you’re enrolled in Medicare, can be claimed as a dependent on someone else’s taxes or have other health coverage.

2. Contribution limits are set each year by the IRS

For 2020 you’re allowed to contribute up to $3,550 for the year to an HSA if you have self-only HDHP coverage. Families can funnel up to $7,100 in an HSA. You can put aside even more if you are age 55 or older: The IRS allows an additional $1,000 catch-up contribution.

Some employers contribute to HSAs on behalf of employees either outright or matching a percentage or amount workers contribute. Those contributions count towards the total.

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Other HSA rules about contributions to note:

  • If both you and a spouse have HDHP coverage under separate health insurance plans, your total maximum allowable contribution for the year is $7,100 if you’re under 55. If you’re both over age 55, you can each make an additional $1,000 catch-up contribution in your own HSAs.
  • The amount you’re eligible to contribute is reduced by any contributions your employer makes to your plan that are excludable from your income.
  • If you were not covered by an HDHP for the entire year you’re allowed to contribute a prorated amount to an HSA. Use IRS Form 8889 to calculate the amount. (If you set up an HSA for yourself, use the same form to report contributions, distributions and figure out your HSA deduction.) 
  • You’re not allowed to continue to contribute to an HSA once you’re over age 65 and enrolled in Medicare. But HSA rules allow you to still use the money to cover out-of-pocket medical expenses. 

3. You can only use the money for certain expenses

The IRS has a complete list of “qualified” expenses. It’s wide-ranging and includes prescription drugs and insulin, co-pays, eye exams and corrective treatments and dental costs (excluding teeth whitening) and more. (Here’s an exhaustive list of HSA eligible expenses.) 

If you have a family plan, you can use HSA money for your own expenses and those of your spouse and dependents on your plan. 

Note: Insurance premiums do not count as a qualified expense except for long-term care insurance (up to certain limits), continuing healthcare coverage (e.g. under COBRA), coverage while you’re receiving unemployment insurance under federal or state law, and Medicare coverage if you’re 65 or older. 

If you use your HSA to pay for an expense that’s not on the approved list, you’ll pay a 20% penalty tax on the distribution on top of what you owe in income taxes up until age 65 (or if you become disabled). If you use HSA money for non-medical expenses after age 65, the penalty goes away, but you’ll still owe ordinary income taxes. 

4. HSAs provide a triple tax break

We mentioned earlier that you fund an HSA with pre-tax dollars. That’s tax break No. 1: The money you contribute to an HSA reduces your taxable income on a dollar-for-dollar basis for the year. So if your household income is $75,000 and you contribute $7,100 to an HSA, you’ll be taxed on just $67,900. 

HerMoney Tip: Contribute fully to an IRA, too, and based on the example above you’ll lower your taxable income to $61,900. Here’s how to open an IRA and guidance on which type of IRA is right for you

The second tax break comes when you pull money out of your HSA to pay for healthcare expenses. The money you withdraw is tax-free. So, depending on what tax bracket you’re in, that’s like using a 15%- to 30%-off coupon on prescriptions, co-pays and other qualified medical expenses.

The final tax-slashing benefits occur within the account: The money sitting in your HSA grows tax-free. That’s a big advantage if you’ve got your eye on building your long-term savings cache. Because unlike an FSA where your money sits in cash, HSA rules allow you to invest your savings for growth. 

5. An HSA may very well save your retirement

We could not wait to get to this part! An HSA isn’t just a parking spot for cash. An HSA can also be a long-term, tax-favored investment account to help dramatically cut your future healthcare costs and protect your other pools of wealth. Having an HSA with an investment component enables you to build up a healthcare war chest for those pricey retirement years. A few considerations: 

  • Make sure the account you open (at a brokerage, bank or credit union) provides access to investments like mutual funds with higher growth potential. Many HSA providers provide access only to Certificates of Deposit or money market accounts. (Compare offerings, minimums and account fees at HSASearch.com.) 
  • Play it safe with any money you plan to use for health-related expenses in the next three years. Don’t expose that money to the swings of the market. Stick to cash or CDs. 
  • To build up your healthcare war chest for the future (for those pricey retirement years), pay for medical expenses out of pocket for now. The longer you let your HSA grow tax-free, the bigger your healthcare war chest will be. 

Consider this example from Fidelity: If a couple in their mid-30s saved $2,820 a year in an HSA, earning an average annual return of 7% and making no withdrawals for 30 years, they’d have a $287,000 tax-free pool of money to cover their unreimbursed medical costs in retirement. 

Even if they didn’t need all that money for health expenses, they could withdraw the money and use it for whatever they want after age 65, and they’d only pay ordinary income taxes — with no 20% penalty.

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