Using Your Health Savings Account to Build Retirement Savings
There are two types of HSAs: the first is for people who have a qualifying high-deductible health plan and the second is for people who have a qualifying HSA-compatible health savings account plan. People with a qualifying high-deductible plan can make contributions to their HSAs and then use those funds later to pay for qualified medical expenses.
Contributions made by an individual are pre-tax, meaning they come out of your gross income and lower your taxable income — just like with an IRA or 401(k). Plus, unlike 401(k) plans or IRAs, there aren't any required minimum distributions at any time in the future. However, you won't be able to withdraw an HSA money penalty-free until you're 65.
The folks who use a qualifying high-deductible health plan are often wise enough to contribute (and pay taxes on) more than the required annual maximum of $3,350 per year. To get the maximum tax benefits from HSAs and avoid the associated 10% penalty for early withdrawal, your total contributions should equal at least $5,500. Even if you need to tap your HSA for qualified medical expenses before age 65, you'll still be subject to a 10% penalty if you make withdrawals prior to age 65 when you're still covered by the plan.
There are several ways to get started with setting up an HSA in the United States. To understand all of the options, it helps to know what an HSA actually is and why you might want one.
What is an HSA?
An HSA is a savings account that you can use to pay for qualified medical expenses after your deductible has been met. The money comes from pre-tax contributions made by you (either as cash or by investing) that grow tax-deferred. You can withdraw money for any reason without paying a penalty at any age, just like a traditional IRA or 401(k).
The great thing about HSAs is that you can start contributing to them before you retire, which means you can effectively save more for retirement. Unlike your 401(k) or IRA that might not be as useful when you're older, the HSA can continue to grow as you get older. An HSA is a great savings account for people who struggle with saving because it is easy to use anytime.
The money also stays in your HSA until the day you die and, unlike an IRA or 401(k), does not go to your beneficiaries unless they pay the associated taxes and penalties on any withdrawals taken during their lifetime.
Typically, when people think of HSAs, they think of the Health Savings Account, which is the tax-advantaged version of the HSA that was created in 2003. The big difference between the HEALTH Savings Account and other health savings accounts is that this tax-advantaged version is designed specifically for high-deductible health plans and cannot be used for anything else. The money in an HSA can't be used to pay for non-medical expenses like vacations or home improvements or any other expenses not related to medical care.
Let's go over the basics of how an HSA is supposed to work.
You make pre-tax contributions into your HSA: you pay no taxes on these contributions.
You use the money from your HSA and your other savings to pay for qualified medical expenses after you have met your deductible: you pay taxes on all withdrawals made from an HSA after the deductible has been met and a 10% penalty on early withdrawals. You can take money out of an HSA penalty-free at any time, even if you're still covered by the plan.
You get a tax deduction for your HSA contributions up to the annual maximum contribution limits: if you're covered by a high-deductible health plan, you can contribute up to $3,350 in 2015 (or $6,650 if you're over 55) every year.
In addition to getting tax savings on any money put into the HSA, you also get tax savings on any withdrawals made for qualified medical expenses after the deductible has been met. You don't pay taxes on money that has already been taxed. Additionally, if you have a hardship and need your money before age 65 because of a qualifying event like disability or unemployment, your funds are still penalty-free.
The Internal Revenue Service (IRS) has a list of Qualifying Medical Expenses and events that qualify for penalty-free withdrawals from your HSA. This includes things like copays, dental care and eye care. You can also withdraw funds to pay for a hospitalization or other out-of-pocket expenses if you are under 65 or because of an employer-provided insurance plan or a Medicare supplement. Some examples of qualifying medical expenses include:
Qualifying medical expenses are different from qualified medical expenses you might have to pay if you're not covered by a qualifying high-deductible health plan with an HSA. If you're not covered by the account's associated health plan, you can use the money in your HSA to pay for qualified medical expenses like deductibles or copays. However, if the associated high-deductible health plan is not an HSA-qualified plan, you can't meet the requirements of an HSA.
Once you've paid your deductible, you can use your HSA to help pay for any kind of medical care out-of-pocket or use it to pay for health insurance deductibles and copays.
It is often a good idea to ensure that your annual contributions are greater than the annual maximums recommended by financial advisors and accountants. This is especially important if you're in or close to retirement. If your HSA contributions are too low and/or your total contributions are greater than the maximums, you'll pay a 10% penalty on any money withdrawn from the account before age 65. The financial advisor who helped you set up your account should have given you that advice.
Qualified Medical Expenses are different from non-qualified medical expenses in that Qualified Medical Expenses include many more items like hospital bills (not just doctor bills), prescription medication, and many other services that aren't covered by insurance plans. Qualified medical expenses do not include things like braces, glasses, contact lenses, cosmetic procedures or dental work such as fillings or crowns.
If you do not have coverage through a Health Savings Account or HOA/HMD then that money in your HSA is going to be taxable earnings. You are also going to be taxed on any withdrawal from the HSA if you are under 65 and it is used for non-medical expenses. However, there are many other ways to pay for these expenses without paying the penalty:
Hospitals – after meeting the deductible, you can pay out of pocket for all covered and non-covered medical needs.
Doctors – if your physician maintains a fee schedule, they will bill you directly up to a certain limit.
Conclusion
If you have a high-deductible health plan through your employer, it is important to keep the money in your HSA. If you don't use the money from your HSA for qualified medical expenses, that money will be taxable income and subject to a 10% penalty from the IRS.
The interest rate on HSA's is typically very low, so all of this money will stay in your account until you die. The maximum annual contributions allowed are low, so even if you contribute a small amount each year, the total contribution should be more than enough to stay ahead of inflation. That makes this account a great way to save for retirement without having to worry about taxes and penalties on withdrawals.