Health Savings Accounts: The underutilized retirement savings vehicle

It might surprise you that one of my favorite retirement savings vehicles is a Health Savings Account.

Health Savings Accounts (HSAs) are tax-advantaged savings accounts intended to be used to save for medical expenses. However, if used strategically, HSAs can be used as a powerful retirement planning tool.

There are three features of HSAs that make them a viable retirement savings vehicle: HSAs are triple tax-advantaged, withdrawals after age 65 can be used for any purpose penalty-free and contributions can be invested in a diversified portfolio.

What does it mean for HSAs to be triple tax-advantaged? First, HSA contributions are made pre-tax, meaning that you get a tax deduction equal to the amount of your contribution. This decreases your tax liability in the year that you make the contribution.

Second, any interest earned in the account accumulates tax-free. Third, if you follow the HSA rules, your withdrawals can be tax-free. HSAs are the only type of account that is triple tax-advantaged.

Not everyone is eligible to contribute to an HSA. HSAs can only be used in conjunction with high-deductible health plans (HDHPs).

For 2021, the IRS defines a HDHP as any plan that has a deductible of at least $1,400 for an individual and at least $2,800 for a family. Annual out-of-pocket expenses (e.g., deductibles, copayments and coinsurance) must not exceed $7,000 for an individual or $14,000 for a family.

Withdrawals from HSAs can be made at any time. However, if your withdrawal is used for ineligible expenses, your distribution will be taxed and you will face steep tax penalties (20% of the distribution for individuals not disabled or older the age of 65). Eligible medical expenses include medical copayments or coinsurance, long-term care costs, dental care costs, vision care costs, prescriptions, medications and over-the-counter treatments.

In 2021, individuals can contribute up to $3,600 to their HSAs and families can contribute $7,200. The contribution limit is increased each year. Individuals older than age of 55 are eligible for an additional catch-up contribution of $1,000 each year.

The basic retirement saving strategy using an HSA works like this: Maximize your contribution to your HSA every year. Claim your tax deduction for your HSA each year. Keep a portion of your HSA balance in cash and available to pay for medical expenses (one or two times the amount of your insurance plan’s annual maximum out-of-pocket expense).

Invest any remaining funds not needed for current medical expenses in a diversified portfolio that aligns with your risk profile (willingness to take risk) and investment time horizon (length of time until you need to take distributions from your account).

Through the years, your balance will grow, not only from your contributions, but also from the investment returns that are accumulating without being taxed. Once you reach age 65, you can use the balance for medical expenses during retirement without ever paying tax on the distributions.

After age 65, if you need to use the funds for non-medical retirement expenses, your HSA can function like your IRA or 401(k) would: Your distributions will be taxed at ordinary income tax rates.

Of course, this retirement planning strategy will be most effective if you use your HSA account for medical costs during retirement and use funds from other accounts to fund retirement living expenses. Even if you don’t need all your accumulated HSA funds for medical expenses, this strategy would be equivalent to getting to put extra money in your IRA and/or 401(k).

However, it is worth planning specifically for increased medical costs during retirement. Many people underestimate how much their medical expenses will be and do not account for the fact that medical expenses will likely increase with age, even accounting for Medicare coverage.

Additionally, prices for health-related expenses are increasing at a rate outpacing inflation, the rising prices of other everyday goods and services.

There are a few other considerations to keep in mind if you are planning to use this strategy. Do your research when deciding which company to use as your HSA provider. Make sure you choose a provider that has the account features you want. Some providers have features that provide a lot of convenience like issuing a debit card and providing a mobile app. You also need to make sure that you know what investment options will be available to you through the HSA provider and that those options will meet your investment needs.

Another crucial consideration in maximizing the long-term success of this strategy is minimizing the fees you will be paying. Keep in mind that investment funds charge expense ratios so you should look for low expense ratios when selecting your investments.

Some HSA providers might charge fees that will eat up your investment returns, leaving you with less money in your account and potentially eroding your balance over time. Some providers charge fees such as account maintenance fees, investment management fees and account closing fees just to name a few.

There are providers that offer fee-free HSAs so make sure you explore your options.