We always hear the paraphrase “nothing is certain in life except death and taxes,” but I think we can all agree that medical expenses could be added to that list. According to Fidelity, an average couple retiring this year is expected to spend $285,000 for medical expenses in retirement – and that’s out of pocket! This estimate doesn’t include the potential cost of long-term care, which can obliterate retirement savings without proper planning. Now that I’ve scared you (sorry!), let’s try to improve our financial plan and determine if a health savings account (HSA) could help!
The benefits of HSAs are incredible, and they are often mentioned as being “triple tax advantaged” – I like to described them as being “quadruple tax advantaged” because they can also avoid payroll taxes, which can’t be avoided with other retirement contributions.
Here is a list of HSA benefits:
- Tax-free contributions (including FICA if contributed directly through a Sec. 125 Cafeteria Plan – ask your employer if your contributions can be made directly from payroll to avoid Social Security (6.2%) and Medicare (1.45%) taxes
- Tax-free investment growth – deferred like other qualified retirement accounts, with the ability to invest in securities (usually once a cash balance is met)
- Tax-free distributions including growth if used to pay for qualified medical expenses – like a Roth or 529 plan but specific to health needs
- No 20% penalty (taxes only) if used to pay for non-medical expenses starting at age 65 – this effectively turns the HSA into a qualified retirement account with a different age requirement
Which medical expenses are eligible for tax-free distributions?
- Medical deductibles, copays, and co-insurance
- Diagnosis, cure, mitigation, treatment, or prevention of disease
- Ambulatory and hospital services
- Eyeglasses, contact lenses, and eye surgery (LASIC, etc.)
- Prescription and over-the-counter drugs
- Menstrual care products
- Medical equipment
- Medical home modifications
- Long-term care insurance premiums (with limits)
- Medicare Part A, B, C, D premiums (not including supplemental policies)
- COBRA insurance premiums
Should I choose a high-deductible health plan?
Contributing to an HSA requires the account owner to be enrolled in a high-deductible health plan (HDHP). These plans are usually great choices for healthy participants who don’t need medical care often, beyond regular checkups. As named, HDHPs require paying higher out-of-pocket deductibles before the insurance co-insurance kicks in. If you expect ongoing medical care or expensive prescription drugs, a low-deductible plan may be a better option, but without the ability to contribute to an HSA.
To qualify as an HDHP in 2020, the deductible must be at least $1,400 for individuals or $2,800 for families. The maximum out-of-pocket expenses must be $6,900 for individuals and or $13,800 for families. These limits are updated annually. Lastly, the health plan must not include benefits beyond preventative care before meeting the deductible. Confirm with your insurance provider that your plan is HSA-eligible, and also be aware that you cannot contribute to an HSA once you enroll in Medicare.
How can I contribute to an HSA, and how much?
As previously mentioned, the “best” way to contribute to your HSA is directly through your employer, since the contributions can avoid payroll (Social Security & Medicare) taxes. Otherwise, you can contribute directly from your bank account – either way you still receive the income deduction. The 2020 contribution limits are $3,550 for individuals and $7,100 for families, with an additional $1,000 if you are age 55 or older. The deadline for annual HSA contributions is April 15th (tax day) of the following year, and they do not have any income limits!
Are there ANY negative consequences of having an HSA?
HSAs do have one potential negative consequence – the beneficiary rules state that any non-spouse beneficiary must inherit and receive the funds as taxable income in the year of death! If the estate is listed as beneficiary, the HSA balance is included on the owner’s final tax return. A charity may also be listed, in which no taxes will be owed. If you are single or widow(er)ed, keep this rule especially in mind. You wouldn’t want to lose the HSA’s tax-deferred benefit and for the inheritance to be a possible tax burden for your beneficiaries.
HSAs are health SAVINGS accounts, not health SPENDING accounts.
Most people use HSAs to pay for current medical expenses, but if you have an adequate emergency fund and income source, you could instead cash flow these expenses and let your HSA grow tax free as an alternate retirement account. Unlike flexible spending accounts (FSAs), unused HSA balances can roll over into future years. If you go this route, keep receipt of your medical payments along the way, so you will have record of the eligible expenses when you later take tax-free distributions. The compound interest and ability to pay for higher medical expenses in retirement is a tremendous opportunity.