One of the best strategies to save for medical expenses during retirement is putting money into a Health Savings Account (HSA).
Many people are aware of the Flexible Spending Account into which they can make tax-deductible contributions on a use-it-or-lose it basis each year — but fewer are aware of its more attractive cousin, also known as the HSA. With the HSA, you can contribute up to a maximum amount each year (currently $3,550 for an individual and $7,100 for a family, increasing by $50 and $100, respectively, in 2020). If you don’t use the money, you can roll the balance into the next year. The contribution is tax-deductible, grows tax-deferred and comes out tax-free if used for qualified medical expenses.
But there’s a catch: you must be enrolled in a high-deductible health plan (HDHP). That essentially means you’re subject to more out-of-pocket medical expense each year than you would be with a lower-deductible health plan. However, it’s also important to note that the monthly premium for an HDHP is typically less than for a low-deductible plan. Additionally, the money you put into your HSA will be deducted from your income, and you won’t pay taxes on it.
“This sounds like a lot of work for a few dollars in tax savings each year,” you might be thinking. Welcome to the power of compounding and the concept that timing is everything. The best way to look at the HSA is as a tool to pay for medical expenses in retirement — not expenses in the present when you’re relatively young and medical expenses are typically lower on average.
The HSA will continue to increase in value by your contributions and the returns generated by investing those contributions. So, let’s say you’re in your 40s, and you put $7,000 per year in an HSA for 20 years until retirement. That’s $140,000 you didn’t pay taxes on and that you will have available to you for medical expenses in your elderly years. If you also invested the $7,000 a year and earned 5% per year over those two decades, you could have almost $250,000 for medical expenses in retirement!
You can use the HSA to pay your Medicare premiums and out-of-pocket expenses, such as deductibles, co-pays and coinsurance. Further, if you are fortunate and don’t need to use the HSA to pay premiums, you can let it continue to grow and leave the HSA to your heirs. Although an HSA left to a non-spouse beneficiary is taxable in the year of your death, a deduction can be taken for any eligible medical expenses you incurred after you opened the account, as long as you kept the receipts and the expenses hadn’t already been reimbursed by the HSA. You should consult your tax advisor if considering this strategy because there are nuances beyond the scope of this article.
For 2019, the IRS defines an HDHP as any plan with a deductible of at least $1,350 for an individual or $2,700 for a family. An HDHP’s total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) can’t be more than $6,750 for an individual or $13,500 for a family. (This limit doesn’t apply to out-of-network services.) These thresholds will also increase slightly for inflation in 2020. An HDHP may provide certain preventive care benefits without a deductible or with a deductible less than the minimum annual deductible. With healthcare plan renewals coming up, take a look at your HDHP options, and if one makes sense in your circumstances, consider contributing to an HSA. Some health insurance companies offer HSAs for their HDHPs. You can also open an HSA through some banks and other financial institutions.
The content contained in this article is meant for educational purposes. Information presented is not meant to be a complete discussion of Health Savings Accounts, plan-specific benefits, or tax advice. The growth of an HSA account is a hypothetical example – market performance cannot be guaranteed. All expressions of opinion are as of its publishing date and are subject to change. Please consult your tax advisor if considering this strategy.