Health care costs in retirement can be one of the major expenses you’ll incur. According to Fidelity, an average couple can be expected to incur about $280,000 in medical expenses alone excluding long term care!
If you don’t plan ahead, this can quickly eat up a large part of your nest egg. Hence it becomes extremely important to plan for your medical expenses wisely.
Fortunately there is an excellent tax advantaged vehicle which has been devised to help you save for your medical expenses. This account is called a Health Savings Account (HSA) and can help you contribute your pre-tax dollars and use them for qualified medical expenses.
You can get access to an HSA account either through your employer’s benefits provider or you can open one yourself with a bank, credit union, insurance company and other approved company.
An HSA account typically requires you to be on High Deductible Health Plan (HDHP). Given the amazing tax benefits associated with an HSA account, let’s find out if an HSA might be the right choice for you.
How Is HSA Different From Other Tax-Advantaged Accounts?
HSA is one of those rare tax-advantaged accounts which gives you the maximum bang for your bucks. Neither a 401(K) nor an IRA or even a Roth IRA comes close to beating this account in terms of its tax advantages. Even if you are considering using money from any of these accounts to cover your medical expenses in retirement, they still fail to beat an HSA.
- Although a 401(k) account allows you put your money tax free and grow it tax free, you end up paying taxes at the time of withdrawal.
- You need to have an earned income in order to qualify contributing to a Roth IRA account.
- You don’t get a tax deduction on the contributions you make to a Roth IRA account even though the growth is tax free. You pay taxes on the way in.
- All of the retirement accounts have penalties for early withdrawal (except for Roth IRA which allows for early withdrawal of you principal amount, under special circumstances).
- There is a required minimum distribution (RMDs) schedule starting at age 59.5 years for 401(k) or 70.5 years for an IRA or SEP IRA. HSA has no RMD schedules!
- If you are healthy and don’t ever need this money, it can be simply transferred to your surviving spouse, once you die. He or she can use it for qualified medical expenses. For non-spouse survivors, the account loses its HSA status and its fair market value becomes taxable to the beneficiary in the year you die.
Reasons Why You Should Choose An HSA
Given the nature of the limitations of the above accounts, they still fall behind an HSA when it comes to tax advantages. Hence an HSA provides an efficient way to meet your medical expenses that no other account can match. Along with the above reasons, here’s 6 reasons why choosing HSA makes more sense.
1. You are healthy and rarely visit a doctor
If you are relatively healthy and rarely visit a doctor, you can quickly rack up savings in an HSA account. This can help you grow your savings and also help reduce your taxable income. If this is you, it should be a no-brainer to start using an HSA account.
2. Lower insurance premiums
A typical high deductible health plan (HDHP) has a lower annual premium compared to a PPO plan. They make up for lower premium by having a higher deductible. A HDHP plan usually pays 100% of the costs after you meet your maximum out of pocket expenses for the calendar year, while PPO plans still require you to pitch in about 10-20% of the costs, depending on the plan.
A quick summary of the contribution limits to an HSA plan for 2018 and 2019 is provided below. Some HDHP plans offered from employers offer an HSA account and also provide an employer match. Although it is not mandatory to offer an HSA account with a high deductible plan.
My current employer has a very generous HDHP plan with Aetna and provides a $4,000 matching contributions for 2019. By providing a matching contribution to my HSA account, I don’t receive any subsidies to my insurance premium though. It is same as PPO or HMO plans on offer. It’s still a great deal for me. Given the annual limits, my actual out of pocket maximum for 2019 will only be $3,000.
3. Ability to invest money in an HSA account
Not only is the money contributed to an HSA account tax free, but you also can grow your money tax free. In my case, the HSA provider is Benefit Wallet and they offer some excellent investment options that include low cost index funds from Vanguard like VITSX. The low cost investments help me grow my money efficiently. If you are in your 20s or even 30s, you are looking at at least 3-4 decades of compounding on your money left in your HSA account. I highly recommend considering HSA account for this reason alone. Invest your money in an HSA account and let compound interest work its magic.
4. Triple tax advantage
The real power of choosing an HSA account is the the triple tax benefit you get. The advantages include:
- Money going into the HSA account is tax exempted.
- Money in the HSA account grows tax free.
- If distributions are used for qualified medical expenses, they are tax exempted too.
Last but not the least, money in a HSA account can be used for non-qualified medical expenses after the age of 65. However, doing so can attract some taxes on the distribution.
Caution: If you use money in an HSA account, before the age of 65, for a non-qualified medical expense, you could incur a 10% tax penalty
5. Once-Per-Lifetime IRA Transfer
A little known provision related to HSA is the ability to roll over money from a traditional IRA or a Roth IRA into an HSA account. You can make the tax-free rollover from your IRA to an HSA only once in your lifetime, and the amount is limited to the maximum HSA contribution for the year minus any contributions you’ve already made for the year.
Note: If you are considering rolling over money from your IRA to HSA, consider your traditional IRA account first since you could avoid taxes on the money rolled over. It is usually a good idea to contribute fresh money to an HSA account and use rollovers only when you are out of options and can’t access your money before the age of 59.5 years without penalties.
6. Stretch your tax advantaged dollar even more
This has to be one of the coolest hacks if you really want to squeeze the last penny out of the tax advantaged dollar in your HSA account.
In order for this to work, you can use a cashback rewards card with the maximum cash back and pay for all your medical expenses using the credit card. You can then reimburse yourself in 2 ways:
- Reimburse immediately – This allows you to pay off the credit card bill using tax exempt dollars and make some money with the reward points.
- Reimburse in the future – If you can manage to pay your medical expenses without dipping into your HSA account and store all your medical bills, you can use the tax free growth on the money in your HSA account and pay yourself. This is the farthest you can stretch your tax advantaged dollar.
If you are switching to a HDHP plan for the first time, I highly recommend checking with your employer if you can front load some money into your HSA account. Since some employers split their matching contributions evenly over each paycheck for the entire year, you may want to have at least your part of the contribution made available in your account upfront. This can come in handy, should you need to visit a doctor in the first month of the calendar year itself.