Can HSAs Solve Our Retirement Problems?

by: Evan Powers


While health care reform seems to be on hold for now, the ongoing debate in Washington cast renewed attention on Health Savings Accounts (HSAs), which provide numerous tax benefits.

In addition to being "triple tax advantaged" when used for medical expenses, HSA balances can also be carried forward indefinitely, and used like IRAs if saved until retirement age.

The flexibility that HSAs afford make them an underutilized weapon in most individuals' financial planning arsenal.

Alas, not all people qualify to contribute to HSAs, since they are only compatible with high-deductible insurance plans, which don't make sense for everyone.

However, balancing the totality of one's financial situation must be taken into consideration before deciding whether or not an HSA-eligible insurance plan is right for you.

While the Republicans' "repeal and replace" American Health Care Act has been withdrawn for now, unceremoniously left to wither on the vine as Congress attends to other matters, it's likely that it will be revived in some form or fashion in the near future. If and when it does return to the front pages of our favorite newspapers and websites, we can expect to again hear a lot about Health Savings Accounts (HSAs), which seem likely to be a cornerstone of any Obamacare replacement plan.

Unfortunately, HSAs alone are probably incapable of solving our nation's healthcare woes, for a variety of reasons. That said, just because the accounts won't be a panacea doesn't mean that we shouldn't be paying attention - after all, if properly utilized, they could be the key to a happy retirement for many of us. That's right, the specific provisions and benefits of HSAs mean that they're not necessarily limited to being a simple healthcare add-on tool, despite what their name might suggest.

On the contrary, HSAs are potentially more powerful than any IRA, 401(k), 403(b), or deferred compensation plan could ever be when it comes to saving for retirement. If you're eligible for an HSA (or even if you aren't, but could be), read on to see how you might better utilize HSAs to prepare for multiple financial goals at once.

How do HSAs work?

The first thing to understand is that HSAs, much like Roth IRAs, are not actually available to everyone. In order to be eligible to contribute to an HSA in a given year, an individual must first be enrolled in a qualified high-deductible insurance plan (HDHP, per IRS parlance). Medicare recipients are also not eligible, nor are individuals who are claimed as dependents on anyone else's tax return, or certain other excluded individuals.

The high-deductible plan is an attractive approach for many people since the plan typically comes with lower monthly premiums. However, the higher deductible can also mean higher overall out-of-pocket costs, which cannot be easily covered by many lower-income individuals. As a result, the benefits of HSAs do tend to be concentrated among wealthier individuals with greater cash flow flexibility (the tax benefits are also greater for higher-income individuals, a point that I'll revisit shortly).

For those who are eligible, though, an annual contribution of up to $3,400 for an individual (up to a family maximum of $6,750) can be directed to an HSA. Like 401(k) deferrals or traditional IRA contributions, HSA contributions are fully tax-deductible in the year of the contribution (as an above-the-line deduction), allowing for immediate tax relief. Of course, that immediate benefit also carries greater weight for higher-income individuals and families - for those in the top marginal tax bracket, the deduction benefit can be as much as $2,800, as compared to just $1,000 for those earning around the median household income of $50,000.

However, the year-one tax deduction benefit is far from the only tax-related benefit of HSAs. In fact, HSAs stand alone in that they are "triple tax advantaged," which is something no other retirement or savings account can claim. In addition to the contribution-year income tax deduction, investment returns earned within HSA accounts are also tax-deferred, again like their retirement plan cousins. However, unlike retirement accounts, withdrawals from HSAs are completely tax-free if used for qualified medical expenses, as defined by the IRS. Therefore, any money directed to an HSA and subsequently used to cover medical expenses will completely avoid taxation, even after investment returns are taken into account.

But what ultimately sets HSAs apart - and what lends them their uniquely flexible nature - is what happens to the funds if they are not needed for medical expenses. For one, HSA funds that are not used in the year of the contribution can be carried forward indefinitely, until they can be used. This sets them apart from their Flexible Spending Account cousins, which are in most cases subject to a "use it or lose it" provision, whereby unspent money disappears and cannot be carried forward.

Furthermore (and perhaps most importantly), if funds are held in the account until age 65, any remaining funds essentially convert into traditional IRA funds - they can be withdrawn and used for general living expenses without penalty, incurring only ordinary taxes (thereby turning the "triple tax advantage" into a mere "double tax advantage"). In that way, HSAs can be considered something of a hybrid savings vehicle - funds can either be saved for medical expenses or for retirement savings, and only their tax treatment will differ. This contrasts sharply with, for example, 529 plans for college savings, which can incur steep penalties if used for any purpose other than college tuition and fees (even secondary school tuition is not a qualifying expense). The hybrid nature of an HSA makes it a particularly attractive savings option for anyone who is eligible to contribute.

The drawbacks of HSAs

Alas, no great opportunity comes without certain drawbacks. While the primary limitation of HSAs is the eligibility restrictions mentioned above, they also aren't exactly the most user-friendly of tools. Using HSAs properly means keeping meticulous records of any contributions and distributions, which means sorting through our nation's often confusing and arcane medical billing procedures. That headache alone can prevent many people from going the HSA route, as they are unwilling to take on the recordkeeping burden that the accounts require.

In addition, HSA custodians are much fewer and farther between than IRA or 401(k) custodians. The biggest (and best) players in the space generally lack the name-brand recognition that most consumers rely on for comfort and familiarity, which makes it much more difficult to make a confident decision. When combined with the fact that HSA oversight has traditionally been much more lax than retirement plan oversight, an uneducated consumer can be fairly easily taken advantage of if they're not careful. Perhaps not surprisingly, investment-related fees can often be quite high in HSA plans, which can fairly rapidly erode any tax-related benefit of using them.

Finally, the simple uncertainty of not knowing when a major medical expense will come along prevents many people from utilizing HSAs to the fullest. Since most HSA users tend to spend the majority of their funds in the year that the contributions are made, it often makes little sense to invest the funds, and the money sits in cash instead (as the above chart shows, more than 85% of HSA assets are held in cash or cashlike investment options). In that case, the "triple tax advantage" of HSAs is illusory, since only two of the three legs of the stool will ever really come into play. That dynamic, of course, significantly alters the calculus of deciding whether or not to use an HSA.

To spend or to save?

To that last point, once a contribution to an HSA has been made for a given year, savers have three basic options: They can use the funds to cover current-year medical expenses, or they can let funds accumulate and begin earning investment returns as a "rainy day" fund (to cover either an unexpected future medical expense or Medicare/Medigap premiums in retirement), or they can bypass the medical use entirely and simply treat their HSA as an additional retirement savings vehicle, to be used alongside any IRAs or 401(k) plans.

The best way to use an HSA (and whether to contribute to one in the first place) can vary from person to person, depending on health status, overall financial condition, risk tolerance, and which other resources and retirement plans are available to the person (or family) in question. Decisions about health care and HSAs should not be made in a vacuum, but must be considered in a broader financial planning context. In many cases, it can definitely make sense to contribute to an HSA, but use other cash to cover medical expenses (for a more in-depth discussion of that point, this article provides a very solid overview).

With the future of retirement accounts continually in flux, it may be that HSAs find themselves as an increasingly central part of many individuals' retirement planning process, much as Roth IRAs have gradually eaten into Traditional IRAs' once-dominant market position. In an increasingly uncertain world, flexibility is often the name of the game, and when it comes to flexibility, the HSA wins the race running away.

Unexpected medical expenses have long been the #1 cause of bankruptcy, but with intelligent use of HSAs, we might be able to change that statistic, while also making progress toward solving our nation's ongoing retirement crisis. No one tool can solve all our economic ills, but it certainly seems like HSAs represent an underutilized weapon in our arsenal.

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