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Picture of Christopher A. Hopkins, CFA

Christopher A. Hopkins, CFA

Health Savings Accounts: underused tools for retirement

US healthcare costs accelerated nearly twice as fast as inflation over the past 40 years, prompting employers to adopt insurance plans with higher deductibles. In conjunction, Health Savings Accounts or HSAs have also grown as a means of assisting individuals in shouldering the greater cost burden. But far beyond health insurance, an HSA can be one of the most tax-efficient retirement savings wrenches in your toolkit – 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 for the purpose of covering deductibles and other unreimbursed medical expenses. But these unique accounts provide potentially triple-tax-free retirement investing opportunities that are widely underappreciated by a large percentage of Americans to whom the option is available.

Early experiments with tax-advantaged medical accounts trace back to the introduction of the Archer Medical Savings Account (MSA) included in the 1996 Health Insurance Portability and Accountability Act (HIPAA). While we both appreciate and lament the sometimes-onerous privacy policies imposed by the dreaded HIPAA, we may forget that a primary objective of the bipartisan legislation was “portability”, broadening options for employees to retain healthcare coverage across multiple employers (the bill passed in the US Senate by a vote of 100-0). However, the original MSA had design flaws and was not widely embraced.

In 2003, the bill that established Medicare Part D also created the HSA account with incredibly generous tax provisions for employees enrolled in qualified High Deductible Healthcare Plans. Today, over half of all employees with workplace insurance are in HDHC plans. Unfortunately, not all of those plans are HSA-eligible.

Funds accumulated in a Health Savings Account can be used to pay for a wide variety of qualified medical expenses including deductibles, medications, copays, dental and vision care, and even most over-the-counter medications. Insurance premiums are excluded except long term care, continuation under COBRA or unemployment, and Medicare part B and D premiums. There is no time limit for self-reimbursement of out-of-pocket expenses if you retain documentation, and unused balances continue to grow until spent. But that’s just for starters.

Employer contributions are tax-free to the employee, employee deferral contributions are pre-tax, and direct contributions are tax deductible. But importantly, distributions including earnings in the accounts are entirely tax-free if used for qualified expenses at any time. And perhaps most importantly, the funds in the account can be invested in essentially any asset class allowable in an IRA account, so the balance in an HSA can conceivably grow quite large 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 a 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 $1,000 catch-up for individuals 55 or over. Depending upon a saver’s tax bracket, paying expenses out of pocket and allowing the HSA to compound tax free could provide the most bang for the buck of any retirement vehicle. As an example, an individual who contributes the maximum each year for 30 years invested at a 6% return would escape taxation on over $125,000 of income and amass around $320,000 of tax-free money to cover Medicare and other health expenses in retirement, roughly equal to the average expected out-of-pocket medical costs for a typical senior.

HSA consultant Devenir Group estimates that Health Savings Accounts now hold over $100 billion. But apparently few people either recognize or exploit the unparalleled tax benefits of this opportunity. According to Employee Retirement Benefit Institute, 69% of account holders use them primarily to cover near term expenses. The ERBI found that one third viewed HSAs as an investment vehicle, but only 11 percent actually held investments in their accounts.

There are other restrictions to be aware of. Withdrawals for qualified expenses are tax free, but if the money is extracted for non-qualified reasons, the HSA essentially becomes an IRA subject to ordinary income tax as well as a 20% penalty if the holder is under 65. Spouses can inherit an HSA as their own along with its tax-free status. Non-spousal beneficiaries must take a cash distribution and pay ordinary income tax. What’s not to like?

But before getting too excited, note that this opportunity is available only to US workers 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 out of pocket maximum of at least $7,500 ($15,000 per family).  The HSA can be funded through contributions from the employer as well as employee deferral or direct contributions up to the statutory maximum. If your plan is HSA-eligible, you can open your own HSA even if your employer does not contribute.

To be sure, HSAs offer especially attractive benefits to a relative minority of workers, that whether by design or accident benefit high-income workers the most. But for those who can use them, HSAs should be viewed through the wider lens of retirement investing and not as just a short-term medical savings account.

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