Health Savings Account: Your Extra Retirement Funds

What if I told you there was a way to save $2.5 million tax-free forever? Interested?

By now you’ve probably heard about the health savings account (HSA). It was invented by Congress in 2003 as a way to give people more control over how their money was spent on healthcare. The idea was simple: if we can get more people to spend less on healthcare premiums and take the difference and stick it in an account, then we will lower healthcare costs over time. Why? Because individuals will be “voting with their dollars” on healthcare services, thereby increasing competition and lowering costs.

Whether or not the theory has panned out is open to debate, and not really the point of this post. So I’ll spare you the political pontification. Instead, let’s talk about a way to use an HSA more as a retirement plan than as a savings account for healthcare expenses. (For related reading, see: How and When to Use Your HSA Funds.)

How Health Savings Accounts Work

Let’s start with the basics. First, it’s important to remember that an HSA can only be funded by someone covered by a high-deductible health plan (HDHP). HDHPs are health insurance plans with lower premiums but higher out-of-pocket costs, and with the rise of healthcare costs in the United States over the last decade, they have grown significantly in popularity. Generally speaking, someone with an HDHP will pay for their own expenses to the tune of several thousand dollars before the insurance plan will kick in.

Now while paying out-of-pocket for healthcare is annoying, especially for those used to the more traditional health insurance plans with low deductibles and co-pays, the tradeoff is a lower monthly premium for the HDHP. And for catastrophic situations involving tens of thousands of dollars in medical bills, HDHPs offer full protection once the patient’s share of the costs reach the plan’s maximum out-of-pocket limit. For younger folks in good health, they usually come out even or slightly ahead with an HDHP due to the lower monthly premiums.

Second, the HSA is simply an account where you can contribute funds tax-deferred (i.e. untaxed) to be used in case of medical expenses that have to be paid out-of-pocket. If no healthcare expenses are incurred, then the funds in the account can be rolled over from year to year, all the way to retirement age and beyond. Some health savings account providers allow you to invest the funds in stock mutual funds, thereby allowing the account to compound over time. More on that in a minute… (For more from this author, see: How Much Does Frivolous Spending Cost You?)

The Tax Benefits of a Health Savings Account

HSAs are unique in that they are the only account that gets a tax deduction on the contributions, can grow completely tax-free for years, and, if used for medical costs, are tax-free when withdrawn. There is absolutely no other account in existence that has this triple tax benefit!

Now, if you open and use a health savings account every year as intended, it’s a pretty sweet deal. Triple tax bang for your buck, you can’t beat that, right? Well, actually you can. I don’t use an HSA as intended; instead, I fund my HSA every year and never take a withdrawal, even if I have qualifying medical expenses. Why? Because to really maximize the tax benefits you want to delay withdrawals to enhance the tax-deferral effect. So I use my HSA as a supplemental retirement plan and plan to not take any withdrawals until age 65 or later.

At age 65, the health savings account allows me to take withdrawals for anything, whether medical expenses or not, without penalty. (Before age 65, non-medical withdrawals are penalized at 20%). You pay ordinary income tax after 65 on non-medical withdrawals, but that’s just like a 401(k) or IRA. Since you’ll probably be in a lower tax bracket in retirement because you won't be working, even that scenario is not a bad deal. (For related reading, see: Should Parents Save Towards College or Retirement?)

But that’s still not the best way to get the money out.

Tax-Free Withdrawals from an HSA in Retirement

Again, any withdrawals for qualified healthcare expenses are tax-free, whether they happen in retirement or not. Now obviously, healthcare expenses tend to increase in one’s golden years, but it’s also easy to underestimate how much money one could accumulate in an HSA if you contribute the maximum every year and never take a withdrawal.

If we assume a hypothetical person starts at age 25, and contributes the maximum amount into a health savings account every year without taking a withdrawal before retirement, that account could grow to a surprisingly large amount. Let’s just use a 10% return over that time period, which is approximately the long-term average return of the U.S. stock market. By doing this, I get a whopping $2.5 million account to be enjoyed in retirement! (For related reading, see: Using Your HSA as a Retirement Savings Tool.)

Now even though healthcare costs are certain to be expensive in old age, there is obviously a chance that our hypothetical person will not incur enough expenses to withdraw everything from the account on a tax-free basis. That’s why there’s one more wonderful feature of the HSA to know about.

Health savings accounts also allow you to take withdrawals for medical expenses that happened in the past. Therefore, you could save up hundreds of receipts for expenses you paid decades earlier, and withdraw those funds tax-free in retirement. As long as you have the documentation and you weren’t reimbursed for these expenses by your insurance or your employer, you should be good in the eyes of the IRS.

The Bottom Line

The health savings account presents a marvelous opportunity for the savvy investor to shelter money from taxes. He or she just has to follow a few rules, and avail himself of thousands (even millions!) in tax savings. For more information, please consult IRS publication 969. (For more from this author, see: The Big Difference Between Good Debt and Bad Debt.)