The Secret Retirement Account

David J. Haas CFP^®, November 15, 2018

What if I told you that there was an account out there that you could contribute money to, take a federal tax deduction, thus lowering income taxes? You also don’t pay any taxes on investment gains every year and once you take the money out you won’t owe any taxes either. Not only that, there are no income restrictions limiting even wealthy people from contributing the maximum amount of money. Even if you retired early and are no longer earning income you can take advantage of this account. I’m not pulling your leg, this account really exists! You might have heard of it, but it was presented to you as something different from what it really is. The account is the Health Savings Account or HSA.

Health Savings Account

The Health Savings Account was part of the Medicare Prescription Drug, Improvement, and Modernization Act signed by President George W. Bush in late 2003. It was established to replace the older Medical Spending Account. The HSA allows Americans to save for their own medical care. The idea was to lower medical insurance premiums by encouraging Americans to buy High Deductible Health Plans (HDHP). You would pay a lower premium for your health plan and then save the difference in an HSA and use it to pay for the expenses during the year which were still part of the deductible. If you never met the deductible, then the funds would accumulate in the HSA. The HSA was yours to keep and you could invest the account if you wanted.

You might not be very excited about an account like this, but this account is a fantastic retirement savings vehicle. You just have to think of it that way.

Contribution Rules

You can only contribute to a Health Savings Account in a year when you have a High Deductible Health Plan. For 2018 and 2019, this is a health plan which has a deductible of at least $1,350 but not more than $6,650 for single coverage or at least $2,700, but not more than $13,300 for family coverage. Many people have HDHPs today, since deductibles in general have gone up. When you compare the price difference between plans with lower deductibles and HDHPs, you typically find the difference in premium price is exactly the difference in the deductibles. In other words, if you usually don’t meet the HDHP deductible each year, its usually better to get an HDHP anyway because of the savings in premiums. If you meet the deductible each year, it won’t make much difference because you either pay with the higher premium or the higher deductible.

In 2018 the contribution limit for Health Savings Accounts are $3,450 for individuals and $6,900 for families. In addition, if the account holder is age 55 or older, they can contribute an extra catch-up contribution of $1,000. These contributions are fully deductible from your taxes whether or not you are employed. In 2019, the contribution limits go up to $3,500/$7,000 and the catch-up is still $1,000.

Withdrawal Rules

You can take money out of your HSA account any time you want. Your distributions from your HSA are tax-free as long as they are used for approved healthcare expenses. What kind of healthcare expenses? It’s anything which is eligible for the medical expense itemized tax deduction and includes expenses not covered by such as including deductibles and copays. It also includes uncovered dental expenses, hearing aids, and prescription eyeglasses. It does not include over-the-counter medications.

One important thing to realize is that the medical expenses do not have to be from the current year. The expenses might have been incurred in a past year. You can use them as long as they were never reimbursed by insurance or used for an itemized tax deduction or previous HSA distribution. You should keep good records and have receipts and/or insurance Explanation of Benefit (EOB) documents to show the IRS in case you get audited. I personally keep scans of all my medical, dental, and vision receipts and EOBs on my computer just in case.

If you take a distribution from your HSA and do not have an offsetting medical expense, then you will owe taxes on the distribution plus an extra 20% penalty.

You are not allowed to claim any amount reimbursed from an HSA as a medical itemized tax deduction.

Special Withdrawal Rules

There are some special rules for distributions. If you ever find yourself unemployed and on COBRA continuation insurance, you are allowed to take HSA distributions to pay your COBRA premiums. Once you retire, you can take HSA distributions tax-free to pay your Medicare premiums.

How to REALLY use an HSA

An HSA is really a unique tax-qualified account because you can take a tax deduction on the funds going into the account, invest the account, and then take the original contributions plus all the earnings out of the account tax-free. You will get maximum benefit from an account like this if you start investing in it when you are young and then keep contributing to it for a long time, taking it out after retirement. This means you contribute money into the account and not take any distributions for health-care expenses while you are working. Pay for your deductible and copayments using your regular earnings or savings instead. You have to think of your HSA as a retirement plan and not a “Healthcare” account.

Savings Order

Here is the order to think of with saving into tax-qualified retirement accounts: 1) Save enough in your 401(k) to get your company match. 2) Save as much as possible in your HSA. 3) Save in a ROTH IRA if you are eligible. Max it out. 4) If you still have funds available, then max out the rest of your 401(k) or 403(b) plan. Of course, you should make sure you have enough money in your emergency fund before you think of saving for retirement.

Invest Your Account

Your employer will give you an account for your Health Savings Account, but you get the best benefit by investing your HSA. You might have to wait until there’s a certain amount in the account, maybe $6,000-$10,000, but then see if your employer has an option to invest the account in mutual funds. They usually do.

You also don’t need to use your employer’s HSA. They like to make you think that you do, but you can take the contribution deduction on your tax-return and you can open your HSA at any provider. You just make the contribution yourself and don’t set up any payroll HSA contribution. You may also be able to transfer your existing HSA to a new provider. You can definitely do the transfer when you have left your employer, but you can ask if you can make this transfer even when you are still employed. Just make sure you do a direct custodian-to-custodian transfer from HSA to HSA. Anything else might cause a taxable distribution.

Wait Until Medicare to Take Distributions

I recommend waiting until you are eligible for Medicare before taking any distributions. Even then, you can decide how much to distribute tax-free each year. It does not have to be the entire amount you might be eligible to distribute. Even if you are paying your Medicare Part B premiums using Social Security, you can still distribute the amount up to your total Part B premiums every year from your HSA tax-free (but you can’t then claim these premiums as a tax deduction). You can also deduct Medicare Advantage (Part C) premiums and Part D prescription drug premiums, but Medicare Supplemental plan premiums (Medigap) are not eligible.

Be Careful

There are a few things to watch out for with HSA accounts. First of all, to use it as a retirement account it means you need to have enough funds to pay your HDHP deductible every year, especially if you and your family wind up needing enough health care to use up the deductible. You don’t want to go into debt just to fund your HSA and keep the money, so if you really need the account to pay your health expenses, then use it for that.

Secondly, the HSA is not a great account for your heirs other than your spouse. Your spouse can inherit your HSA and then treat it as her/his own. But if someone else inherits your HSA, then they need to take a full distribution in the year of your death. This distribution will be taxable although there is no penalty. This could provide an unexpected tax burden and could push your heir into a higher tax bracket for all their income. This is one reason why I recommend starting to use the HSA to pay medicare premiums as soon as you are eligible. If you have a lot of previous medical expenses, a deathbed withdrawal from the account would be beneficial.