Health care costs in the United States have risen almost twice as fast as inflation over the past 40 years, prompting employers to adopt insurance plans with higher deductibles. At the same time, Health Savings Accounts, or HSAs, have also grown as a way to help individuals shoulder the greatest cost burden. But far beyond health insurance, an HSA can be one of the most tax-efficient retirement savings keys in your toolbox — if you qualify.
The Health Savings Account is a hybrid that incorporates the best features of Roth IRA and 401(k) plans. It was created to allow employers and employees to contribute pre-tax funds to cover deductibles and other unreimbursed medical expenses. But these unique accounts offer potentially triply tax-free retirement investment opportunities that are grossly underestimated by a large percentage of Americans to whom the option is available.
Early experiments with tax-advantaged medical accounts date back to the introduction of the Archer Medical Savings Account included in the Health Insurance Portability and Accountability Act of 1996 (HIPAA). While we both appreciate and lament the sometimes onerous privacy policies imposed by the dreaded HIPAA, we can forget that one of the main purposes of the bipartisan legislation was “portability,” expanding options for employees to maintain a health care coverage from multiple employers (the bill passed in the US Senate by a vote of 100-0). However, the original medical savings account had design flaws and was not widely adopted.
In 2003, the bill that established Medicare Part D also created the HSA account with incredibly generous tax provisions for employees enrolled in high-deductible qualified health care plans. Today, more than half of all employees with workers’ compensation insurance participate in high-deductible plans. plans. Unfortunately, not all of these plans are eligible for the HSA.
Funds accumulated in a health savings account can be used to pay for a wide variety of eligible medical expenses, including deductibles, drugs, copays, dental and vision care, and even most over-the-counter medications. Insurance premiums are excluded except for long-term care, continuation under COBRA or unemployment, and Medicare Part B and D premiums. There is no time limit for self-reimbursement of expenses personal if you keep the documentation, and unused balances continue to grow until they are spent. But that’s just to start.
Employer contributions are tax exempt for the employee, deferred employee contributions are pre-tax and direct contributions are tax deductible. Importantly, distributions, including income in accounts, are fully tax exempt if used for eligible expenses at any time. And perhaps most importantly, funds in the account can be invested in virtually any asset class allowed in an IRA account, so the balance in an HSA can potentially grow quite substantially over time to cover a host of medical expenses in retirement.
Unlike most tax-advantaged savings vehicles, HSAs can be maximized by any eligible participant, regardless of income or tax bracket, likely congressional oversight (shh). For 2023, the maximum contribution for an individual is $3,850 or $7,750 for a couple with family coverage, plus an additional catch-up of $1,000 for people age 55 and over. Depending on the saver’s tax bracket, paying for expenses out of pocket and allowing the HSA to compound tax-free might provide the best value for money of any retirement vehicle. As an example, an individual who contributes the maximum each year for 30 years invested at a 6% return would evade tax on over $125,000 of income and amass approximately $320,000 in tax-free money. to cover Medicare and other health care expenses in retirement, roughly equal to the average out-of-pocket medical expenses expected for a typical senior.
Consultant HSA Devenir Group estimates that health savings accounts now hold more than $100 billion. But apparently few people recognize or take advantage of the unparalleled tax advantages of this opportunity. According to the Employee Retirement Benefit Institute, 69% of account holders use them primarily to cover short-term expenses. The institute found that a third viewed HSAs as an investment vehicle, but only 11% actually held investments in their accounts.
There are other restrictions to be aware of. Withdrawals for qualifying expenses are tax exempt, but if the money is withdrawn for non-qualifying reasons, the HSA essentially becomes an IRA subject to ordinary income tax plus a 20% penalty if the holder is under the age of 65. Spouses can inherit an HSA as their own with its tax-free status. Non-spouse beneficiaries must receive a cash distribution and pay ordinary income tax. What’s not to like?
But before you get too excited, note that this opportunity is only available to working Americans covered by a qualified, high-deductible healthcare plan. For 2023, an HSA-eligible plan must include a deductible of at least $1,500 ($3,000 for a family plan) and a maximum of at least $7,500 ($15,000 per family). The HSA can be funded by employer contributions as well as deferral or direct employee contributions up to the legal maximum. If your plan is eligible for HSA, you can open your own HSA even if your employer does not contribute.
To be sure, HSAs offer particularly attractive benefits to a relative minority of workers, who, by design or accident, benefit high-income workers the most. But for those who can use them, HSAs should be viewed as part of a larger retirement investment, not just a short-term medical savings account.
Christopher A. Hopkins, Chartered Financial Analyst, is co-founder of Apogee Wealth Partners.