Health Savings Account plans are the fastest growing product in the health insurance marketplace. At last count, 25 million Americans were covered by an HSA plan and the account balances totaled $50 billion. That’s on a par with the gross domestic product of the entire state of Alaska. It’s more than the GDP of South Dakota, Montana, Wyoming or Vermont.
Readers of this post probably think they are quite familiar with HSAs. But did you know that:
- HSAs are the best savings vehicle available under the tax code?
- You can roll your IRA over into an HSA and, at some point in your life, you are foolish if you don’t?
- The best retirement savings strategy is to put the maximum into an HSA and never spend a dime of it until you get old?
- You can invest HSA funds just like you invest IRA funds and (again) you are foolish if you don’t?
I have to admit that I didn’t fully understand these things until I read HSAs: The Tax-Perfect Retirement Account by William Stuart. Most of what follows is based on Stuart’s analysis.
No other savings vehicle can top an HSA.
Not a 401(k) plan. Not an IRA. Not even a Roth IRA.
For starters, deposits to an HSA escape both income and payroll taxes. That can’t be said of the 401(k) deposit. It escapes the income tax, but not the payroll tax. That’s no small matter. Even without adding in the employer’s share, most Americans are paying more in payroll taxes than they are in income taxes.
As for the IRA, those deposits avoid the income tax. But if they are made from wage income, you don’t get any relief from the payroll tax.
During the retirement years, HSA withdrawals for non-medical purposes will face the income tax. But as I show below, your health expenses are going to be huge – larger than what most people realize. HSA withdrawals can be used to pay premiums for Medicare Part B, Part C and Part D, as well as any out-of-pocket medical expenses.
In all likelihood, your HSA funds will never be taxed at all.
By contrast, any withdrawal from an IRA or a 401(k) will be hit with income taxes, regardless of what you do with the money.
At age 70 ½, the government forces you to begin withdrawing (and paying taxes on) funds in your IRA and your 401(k) accounts. There is no such requirement for HSAs. Further, withdrawals from conventional accounts get included in assessing the tax on Social Security benefits. That does not happen with HSA withdrawals, even if you spend the money on non-medical consumption.
Withdrawals from Roth accounts are not taxed. But deposits are made after paying income and payroll taxes. Those are taxes that the HSA holder can expect to escape completely.
You can turn IRA funds into HSA funds.
In 2019, an individual can deposit up to $3,500 into an HSA account and up to $6,000 into an IRA. For reasons just given, you should choose the HSA deposit first. But suppose you do both. The law allows you a one-time roll-over opportunity, which you will want to delay until the retirement years.
At that point you can take funds that would otherwise be subject to forced withdrawals and income taxation and a possibly higher Social Security benefits tax and roll them into an account that can be part of your estate and that will not be taxed at all as long as withdrawals are for qualified medical purposes.
Your need for medical equity is higher than you think.
Stuart cites a Kaiser Family Foundation estimate that out-of-pocket medical expenses for a typical retiree average 41% of Social Security income today and that figure will rise to 50% by 2030. These expenses add up over time. Stuart cites a Fidelity estimate that a couple at age 65 today will spend $280,000 in medical expenses by the time they die. (These estimates include the Medicare premiums.)
HSAs work best when used as savings accounts rather than spending accounts.
In one example, Stuart compares two people, both age 37 and in the 30% tax bracket. They each forgo $3,000 of consumption – increasing that number by $50 a year for 30 years — in order to put funds into accounts that grow at a rate of 6%. At age 67, the one choosing to save through a 401(k) plan has accumulated $304,200 while the HSA saver has accumulated $329,400.
At that point, Stuart assumes annual medical care costs have reached $10,000 a year and they grow at a conventional rate. But because the 401(k) holder’s account is exhausted more quickly and because he must pay taxes on his withdrawals, he will experience a significant depletion of other wealth.
If both individuals live to 101, the 401(k) saver will have spent $409,000 from other accounts while the HSA saver will have withdrawn only $27,000.
Wise saving means wise investment.
Most HSA owners are not investing at all. They use their accounts as spending accounts. That may explain why the average balance in HSAs is only $2,000, However, the law allows account holders to invest funds the way people invest their IRA balances. About one in ten account holders is doing this. The average balance in their accounts is $14,000.