What if I told you there was a way to save two and a half million dollars tax-free forever? Interested?
By now you’ve probably heard about the HSA, or “health savings account.” It was invented by Congress in 2003 as a way to allow 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 a savings account for healthcare expenses.
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 a HDHP will pay for their own expenses out of pocket 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 copays, 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 (e.g. untaxed) to be used in case of medical expenses that have to be paid out of pocket. If no health care 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. And some health savings account providers allow you to invest the funds in stock mutual funds, thereby allowing the account to compound over time.
How Much Can You Contribute to a Health Savings Account?
For 2017, the contribution limits for a health savings account are $3,400 for a single person, or $6,750 for those on a family health insurance plan. Those age 55 or older can contribute another $1,000 as a “catch-up” contribution. And, each year the contribution amount goes up slightly to account for the effects of inflation.
The Amazing 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 benefits from this triple tax benefit!
Now, if you open and use an 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 withdraw, even if I have “qualifying medical expenses.” Why? Because to really maximize the tax benefits you want to delay withdraws 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 401k or IRA. Since you’re probably in a lower tax bracket in retirement because you aren’t working, even that scenario is not a bad deal.
But that’s still not the best way to get the money out.
Tax Free Withdrawals from the Health Savings Account 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 they contribute the maximum every year and never take a withdraw.
If we assume a hypothetical person starts at age 25, and contributes the maximum into an 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 by the way is approximately the long-term average return of the U.S. stock market.* By doing this, I get a whopping $2.5 million dollar account to be enjoyed in retirement!
Now even though healthcare costs are certain to be expensive in old age, there is obviously a chance that our hypothetical person will not have enough expenses to fully withdraw 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 withdraws 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 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!) of tax savings. For more information, please consult IRS publication 969.
*source: according to Morningstar’s 2016 Fundamentals for Investors, the average annual total return of large company stocks in the U.S. has be 10.0%