HSA - The Best Retirement Account?

Interest in personal finance has been on the rise over the last several years. With Instagram and TikTok influencers, government stimulus money from Covid, Robinhood, and Bitcoin, you can’t get too far on the internet without reading something related to money. While there is a lot of garbage out there, there is also a lot of great information. In our practice, I see more and more people understanding the different components of their finances, including their 401(k), IRA, Roth vs Traditional, how interest rates affect mortgages, etc. But one account that I still see overlooked is the Health Savings Account (HSA).

The HSA is one of a kind when it comes to potential tax savings. While many people think of it as a health spending account, I like to think of it as the ultimate retirement account! Let me tell you why.

An HSA is a type of savings account that lets you put money away pre-tax to pay for qualified medical expenses. Google: “HSA qualified medical expenses”, I think you’ll be surprised at how large the list is of things you can use an HSA to pay for! To be eligible to contribute to an HSA, you must be enrolled in a High Deductible Health Plan (HDHP) and that HDHP must be “HSA-eligible”. In 2023, an individual can fund up to $3,850 and a household with multiple people under a HSA-eligible HDHP can fund a family plan up to $7,750.

I often see households using HSAs in 1 of 2 ways.

1. The ‘Spend It As You Fund It’ method. Most individuals who have an HSA are funding it through payroll at work. As they fund the account, they receive a pre-tax deduction similar to the pre-tax deduction they receive when they invest in their Traditional 401(k). As they have qualifying medical expenses, they use their HSA to pay for those, effectively paying them with dollars that have never been taxed. For households with tight budgets, lots of medical expenses, concerns with investment risk, or simply without the knowledge that they have other options, this is still a fantastic benefit!
2. The ‘Invest to Spend Later’ method. This method is where an HSA can really show its superpower. As I mentioned earlier, funding an HSA is similar to a Traditional 401(k) in that you receive a pre-tax deduction when you fund it. With a Traditional 401(k), the investment growth is tax free but any distributions from the account are taxed. With an HSA, you are able to invest those funds and investment growth and distributions are NEVER taxed as long as it’s a qualified distribution. The HSA is the ONLY account where contributions are pre-tax, any investment gain is tax free, and qualified distributions are tax free as well!

Let’s look at an example of a 35-year-old couple with 2 children. Between them they are contributing 15% to their 401(k)s after their company match. They want to save additional dollars for their retirement but are also concerned about medical costs in retirement, especially Long-Term-Care. If they contribute to a Roth IRA, they will get tax-free growth and distributions in retirement, but what if instead they funded their HSA? Let’s say they have $6,000 before taxes to save. In the HSA, all $6,000 can be used because of the pre-tax deduction. With the Roth IRA only $4,500 enters the account (assuming a 25% Fed & State Income Tax). Over a 30-year career, assuming a constant $6,000 of savings before taxes from 35 to 65 and a 7% annual rate of return, the HSA will be roughly $600K at age 65. The Roth would be almost $150K less at $450K.

At this point, you might be saying, “Well I need to fund more than just my medical expenses, I’m retired!”. You actually have a few options:

1. As soon as you turn 65, you are able to take penalty-free distributions for non-medical expenses from your HSA. The only catch is that you don’t get the tax-free distribution as you would for qualified medical expenses. The HSA is always tax-free for medical expenses, for non-medical it’s very similar to a Traditional IRA after age 65. Prior to age 65, if you use your HSA for non-medical expenses there is a hefty 20% penalty.
2. Another superpower of the HSA, if you are very organized with your receipts you can actually use prior year medical expense receipts for current year tax-free distributions. You know that $7,500 bill for your 2nd child you paid 30 years ago? Yup, you can use that receipt for a $7,500 tax-free distribution now! As long as the HSA was established when the qualified medical expense happened, it can be used at any time in the future for tax-free distributions.

Lastly, let’s go back to our young couple. After hearing about the amazing tax benefits of the HSA, they decide they want to fund it but still like the idea of completely tax free withdrawals from Roth IRAs. They decide to split the difference and fund each with $3,000 before taxes and pay for any medical expenses that occur out of pocket. Their goal is to use their HSA in retirement as a medical & Long-Term Care fund while the Roth IRA will fund basic retirement needs.

With $3,000 in funding from age 35 to 65, and assuming a 7% rate of return, the HSA will be roughly $300K at age 65. Now in retirement, let’s assume the account only grows 5% per year and they distribute $10,000 per year tax free for qualified medical expenses. At age 85 the account will have over $450K! The account continues to grow after 65 because the $10,000 annual distribution is less than the annual 5% growth. And the $450K at age 85 effectively funds any potential Long-Term Care need!

A 2022 study by the Employee Benefit Research Institute estimated that an average couple aged 65 will need $383,000 in savings to fund medical expenses in retirement. The HSA is an excellent option with a ton of tax benefits that avoids all the complexity of life insurance or annuities with expensive riders. If you’re able to fund an HSA, don’t overlook it!

To learn more or to discuss your investment needs. Please reach out to us at 219-465-6924 or through the Contact Us page on our website.

Mark Rosinski, CFP®, CPA

Wealth Advisor

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