The Power of Health Savings Accounts

How the Least Sexy Savings Account Could be Your Retirement Best Friend

If you or a family member is enrolled in a High Deductible Health Plan (HDHP), Health Savings Accounts (HSAs) offer a strongly-tax-advantaged way to put aside money for inevitable future health expenses.

The Triple-Tax Advantaged Retirement Secret Weapon

When it comes to retirement savings, most people immediately think of 401(k) and IRAs due to the strong tax-advantages they offer. The Health Savings Account, although not as glamorous, offers even more tax advantages that it’s sexier account cousins. HSA are triple-tax-advantaged, meaning that:

1. Contributions to HSAs are tax-deductible
2. Contributions grow tax-free
3. Contributions and Earnings can be withdrawn tax-free and penalty-free if used for qualifying medical expenses (20% penalty applies otherwise)

If tax-deferred Traditional IRAs and tax-free Roth IRAs had a baby it would be the HSA, king of all retirement accounts.

Before we get too carried away, let’s talk about the medical elephants in the room.

Elephant 1: High-Deductible Health Plans

You can only contribute to an HSA if you are covered by a high-deductible health plan. These plans are sometimes referred to as “catastrophic coverage” because they often don’t cover any medical expenses until you’re spent a few thousand dollars out-of-pocket. Many times, however, these plans give the insured person greater flexibility and control by offering lower premiums and providing cash contributions into an HSA account. This effectively moves more risk to the insured person; if you have a year with a lot of unexpected medical expenses, you may pay a lot more out of your own pocket. If, on the other hand, you only go to the doctor once a year for your checkup you may walk away with a decent amount of money left in your HSA while spending less on insurance premiums.

For many young healthy people, a high-deductible health plan can be a good choice. Typically the premiums are lower while still providing coverage for catastrophic illness or injury. The HSA can also become a valuable savings vehicle in addition to lessening the impact of medical expenses. If you are someone who doesn’t normally spend a lot of money at the doctor’s office or on prescription medications, a high-deductible plan may be a good choice for you.

Choosing a health insurance plan is an important choice that can have significant impacts on your health and your financial wellbeing. Before choosing a health plan, review your options, estimate your ongoing medical expenses, and choose the plan that is right for you.

As always, do your research and run the numbers prior to making a health plan decision.

Elephant 2: Qualifying Medical Expenses

At first glance, locking up your savings in an account that can only be used for medical expenses sounds like a raw deal, right? After all, you may be a healthy young whipper-snapper with minimal medical expenses. Here are some reasons why you may still want to max out your HSA each year you are covered by a HDHP.

1. You can invest the money just like an IRA: Once you have contributed cash to your HSA — just like with your IRA — you can invest the money into stocks, bonds, index funds, etc. This means the money can grow tax-free for your bad future self.
2. The list of eligible expenses is broad: The list of qualified medical expenses includes items such as copays, prescription drugs, medical equipment, glasses/contacts, and long-term care. This means you shouldn’t have trouble finding qualifying expenses in your lifetime, especially as you age.
3. You can use the money for dependents: HSA funds can be used for medical expenses for dependents such a children and elderly parents you claim on your tax return.
4. At age 65, it becomes a Traditional IRA: Once you turn 65, the 20% penalty disappears and the funds in your HSA are treated like a Traditional IRA for tax purposes. This mean that even if you “save too much” in your HSA, the funds can supplement your other retirement funds in your retirement.
5. You don’t have to reimburse yourself right away: There are no rules about when you have to reimburse yourself from your HSA. This means that you could track expenses and keep receipts while letting the money grow tax-free in your HSA. Then, many years down the line, you can withdraw all those years worth of qualified medical expenses without taxes or penalties.
6. Long-Term Care is insanely expensive: According to LongTermCare.gov, as of 2016, the average monthly cost of a private room in a nursing home was $7,698 per month. And if you’ve ever been in an average nursing home, it’s likely not a place you’d like to be. That’s over $920k for a 10-year stay. It’s a near certainty that you or someone you love will need long-term care at some point in their lives, so it’s best to be prepared. Remember that Medicare will only pay for long-term care once you’ve spent down all of your assets and are essentially broke. Until then you are on your own.

An HSA for Wally WhipperSnapper

Let’s take the example of our friend Wally WhipperSnapper. Wally is a bright-eyed fresh-out-of-college young professional on his first day as a data analyst at Sammy’s Salty Sardines, LLC. In addition to filling out his W-4 and 401(k) paperwork, Wally has to pick out a health insurance plan. Let’s take a look at why Wally may want to choose a high-deducible plan and max out his HSA contributions.

Young working years: In his 20s and 30s Wally is covered by a high-deductible health plan and contributes the maximum amount each yeah to his HSA. He remains a healthy, energetic fellow who sees his doctor each year for a checkup, gets his teeth cleaned every six months, and spends a few hundred dollars a year on glasses / contact lenses. We’ll say he spends $500 each year on qualified medical expenses. Wally diligently keeps his receipts but pays out-of-pocket and invests 100% of his HSA in an S&P 500 index fund, yielding 7% real return annually.

End of working years: When Wally turns 50, he has saved enough to walk away from full-time employment and decides to quit his job and stop contributing to his HSA. He remains relatively healthy but feels nice having $336k in the bank to spend on medical expenses as he ages.

Aging up: At age 60, even through Wally has stopped contributing to his HSA, his account has continued to grow and compound. Wally has over $650k in his HSA and feels pretty confident that this will support his medical needs for some time. As Wally is approaching full retirement age and running low on funds in his non-retirement accounts, he decides to take a $19.5 distribution from his HSA to cover nearly 40 years of qualified medical spending (remember those receipts?). This money is tax and penalty free and Wally can spend it however he likes.

Full retirement: From ages 60 to 65, Wally continues to pay himself back for his qualified medical expenses and his HSA continues to grow. By the time he turns 65, Wally has $886k in his HSA. At this point Wally can treat his HSA as a traditional IRA and withdraw money as he pleases, subject to normal income tax. He can also continue to use the money tax-free for qualified medical expenses such as long-term care and hospital stays, which at $8-10k a month, could easily reach over $1 million in his old age.

A modest $3,850 contribution for the duration of his working years has grown into a large nest egg for Wally which he can use for inevitable medical care in his old age, or treat as another tax-advantaged account once he reaches 65.

We can summarize Wally’s HSA in the table below. For the sake of simplicity we ignore inflation and use 7% as the historical real return on the S&P 500.

An Insurance Policy for the Smart Saver

Health Savings accounts are often-overlooked savings vehicles, but as we’ve seen today they can provide a triple-tax-advantaged safety net for those willing to set aside money each year to fund them.

Memento Mori

As humans, we tend to underestimate the probability of bad things happening but always remember that one day you will be old and wrinkly. But it’s not all doom and gloom; HSAs give our younger selves the ability to give a righteous high-five to that old wrinkly future self through the space-time continuum, setting up that nice geriatric for a safe, stable, and scenic retirement. Right on, grandpa!