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How to Use an HSA in Retirement Planning

A man planting a tree. Like using an HSA in retirement planning

The intent of high-deductible health plans (HDHPs) is to help offset the rising cost of insurance by giving insured people more agency over the cost and scope of their care. Tax-advantaged health savings accounts (HSAs) incentivize HDHP participants to save money for future out-of-pocket healthcare costs and offset high deductibles. Using an HSA in retirement planning also offers tax advantages that insured people can use to increase retirement savings.  

What Are HSAs and How Do They Work? 

An HSA is a tax-advantaged account that helps people save for future medical expenses. And the tax advantages are significant. Not only can you deduct HSA contributions, but the balance of your HSA grows tax-free. You can also take distributions from your HSA tax-free for qualifying medical expenses. 

What constitutes a qualifying HSA medical expense is quite broad. Everything from over-the-counter medications to glasses, infertility treatment, and first aid supplies can qualify. However, funds withdrawn from an HSA and not used for qualifying medical expenses will be taxed as ordinary income. People under 65 will also pay a 20% penalty on the withdrawal amount. People over 65 will not pay the 20% penalty but will still pay income tax on the withdrawal. 

Who Can Contribute to an HSA? 

Of course, not everybody qualifies to set up and contribute to an HSA. First, your health insurance plan must meet federal criteria to qualify as an HDHP. People currently enrolled in Medicare are not eligible to contribute to HSAs.

For a health insurance policy to count as an HDHP, its deductible must be at least a certain amount. Additionally, its out-of-pocket maximum must be less than or equal to a certain amount. The government sets these amounts, which generally increase every one to three years. 

In 2023, your deductible must be at least $1,500 ($3,000 for a family plan). It can have an out-of-pocket maximum of less than or equal to $7,500 ($15,000 for a family plan). 

Note that if you have separate in- and out-of-network limits, only the in-network limits determine your plan’s eligibility. 

How Much Can You Contribute to an HSA? 

You, your employer, or both can fund the HSA. Contributions to an HSA account are tax deductible on your federal income tax return. The contributions are not deductible on all state income tax returns. 

The federal government also limits how much you can contribute to an HSA. These amounts generally increase every one to three years. 

In 2023, individuals can contribute up to $3,850 for themselves or $7,750 for families. If you are 55 or older, you can contribute an additional $1,000 each year. 

You can contribute to your HSA for a given year by the original tax return deadline (generally April 15 of the following year). 

At the end of the year, any money left in an HSA carries over to the next year for future medical expenses. This is a key difference between HSAs and flexible spending accounts (FSAs), in which account holders forfeit unused funds at the end of the year. 

How Can HSAs Help You Save For Retirement? 

If you’re maxing out other tax-advantaged accounts, such as your 401(k) and IRA, using an HSA in retirement planning can offer an additional avenue for setting aside retirement funds with tax savings. 

Like 401(k)s and IRAs, you can invest HSA funds in securities such as stocks, bonds, mutual funds, and electronically-traded funds (ETFs). You could even self-direct your HSA to invest in alternative asset classes if you’d like. Even if you aren’t already maxing out other tax-advantaged accounts, you may want to consider maxing out your HSA first. Unlike other accounts, an HSA gives you a tax advantage now because you can deduct contributions. It also offers a tax advantage later since you can take out qualifying distributions tax-free. 

Other tax-advantaged accounts will give you one of those advantages, but not both. 

It’s worth noting that you shouldn’t use the funds in your HSA account to pay for your out-of-pocket medical expenses. You can always pay your out-of-pocket costs with non-HSA funds. This will let the funds in your HSA grow for years or even decades, earning investment returns. 

The average 65-year-old retired couple will need about $315,000 in today’s after-tax dollars to cover their healthcare needs in retirement. Using HSA funds for qualifying medical expenses in retirement will qualify for tax-free distributions. 

If you don’t need to take out funds from your HSA in a given year, that’s OK. HSAs don’t have annual required minimum distributions (RMDs) like some other tax-advantaged accounts. 

Ways to Use an HSA in Retirement Planning 

In general, it’s best that you only withdraw HSA funds if you intend to use them for qualifying medical expenses. Otherwise, you will pay income tax on your withdrawals and a 20% penalty. 

Once you have reached age 65, you can withdraw the funds from your HSA for any purpose without penalty. You will, of course, pay ordinary income tax on the funds withdrawn from the account, like a traditional IRA distribution

If your HSA funds outlive you, you can leave them to your heirs. 

If you name a beneficiary other than your spouse, your HSA will close upon your death. Your non-spouse beneficiary must pay taxes on the amount remaining in the HSA. If your spouse is your beneficiary, they can keep the funds as an HSA, even if they don’t have an HDHP. 

Using an HSA for retirement planning can mean you have tax-exempt money to pay for later life health needs without tapping your other retirement savings.

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