Health savings accounts important component of comprehensive retirement plans
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Physicians of all specialties are likely aware of health savings accounts and their use by patients and doctors alike to pay for health-related expenses.
Many may not know that health savings accounts (HSAs) can also offer a triple tax-savings benefit for account holders, as well as create a valuable resource for covering future health care and even long-term care expenses. This article provides a brief overview of HSA basics, explains some of their lesser-known benefits, and outlines compelling reasons for implementing this financial vehicle as part of a comprehensive retirement plan.
Health savings account
An HSA is a useful and beneficial tool for anyone who needs to save money for health-related expenses that are not reimbursed by their high-deductible health plan (HDHP). An HSA is typically owned by an employee, but it can also be funded by both the employee and/or the employer. Some employers may choose to make an initial contribution to an HSA for an employee, and the employee can add to the account through payroll deductions or lump sum contributions.
To be eligible for an HSA, an individual must have an HDHP and no other health coverage. The individual also cannot be listed as a dependent on someone else’s tax return. The IRS sets an annual limit for contributions to an HSA and offers the option of a “catch-up” contribution for account holders who are aged 55 years or older (Figure).
Additional benefits
Those thinking about opening an HSA or increasing contributions to an existing account should be aware that HSAs offer some lesser-known advantages, especially when compared with other commonly used savings and investment vehicles.
- Triple tax advantage. HSAs offer a powerful triple tax advantage. Contributions to an HSA can be made pre-tax (like 401(k) deferrals) or with after-tax dollars. After-tax HSA contributions are deductible from income regardless of income bracket. HSA earnings grow tax-free, and withdrawals are tax-free as long as they are used to pay for qualified medical expenses.
- Rollover of funds. Unused funds in an HSA will roll over from year to year, allowing you to save up for future expenses and avoid the risk for losing unused funds at year-end.
- Contribution and spending flexibility. You can contribute as much (up to the annual allowable limits) or as little as you like to your HSA, giving you full control of your budget. HSAs can be used to pay for qualified medical expenses, such as doctor visits, prescription drugs and dental care. Funds can also be used for over-the-counter medications and long-term care insurance premiums.
- Access to funds. HSA funds can be easily accessed in a variety of ways. Account holders can use a debit card or write a check to pay medical costs directly at the time of service, instead of having to submit claims or waiting to be reimbursed.
- Portability. HSAs are portable, meaning you can take them with you when you change jobs or even when you retire.
Implementation of an HSA
In addition to deploying this tax-advantaged tool to cover health-related expenses, owners of HSAs can use these funds — in tandem with 401(k)s, IRAs and brokerage accounts — as part of an overall retirement savings plan.
An HSA can become even more appealing for individuals approaching or already in retirement. If an individual aged under 65 years withdraws funds from an HSA to pay for non-health care expenses, the amount withdrawn will be subject to regular income tax plus a 20% penalty. The 20% penalty is eliminated for people who are 65 or older, thus creating an opportunity to use the funds in an HSA to pay for housing, travel or other nonmedical expenses during retirement.
Any money not spent on medical expenses can be invested, allowing you to build wealth to meet long-term financial goals. HSAs offer a wide range of investment options that allow account holders to grow their savings over time. When investing HSA funds, it is important to work with a professional advisor who is knowledgeable about the available options and can help select investments that are aligned with the account holder’s risk tolerance and long-term financial goals.
How does an HSA stack up?
Many high-net-worth investors, including physicians, have the income to maximize contributions across the spectrum of retirement accounts, including 401(k)s, Roth IRAs and HSAs. However, when comparing the return potential of various savings and investment options, many are surprised that it can be more profitable in the long run to contribute to an HSA than to a 401(k), even if the 401(k) has an employer match. The reason revolves around the tax benefits of the HSA.
Let's look at an example. If an employer offers a 25% match to an employee’s 401(k) contribution, but the employee faces a future tax rate of 20%, a $1,000 contribution to the 401(k) plan is still worth only $1,000 in future after-tax value. The employer match increases the value to $1,250, but the future tax liability diminishes the account value back to the original $1,000. This scenario nets the same result as the employee contributing $1,000 of pre-tax income to an HSA, as long as the amount withdrawn from the account is used to pay for qualified health care expenses.
Based on this example, one can conclude that those who expect to pay taxes at any rate higher than 20% and can use liquid assets to cover medical expenses can fare better by contributing to an HSA account rather than to a 401(k) plan with a 25% employer match. It could even be argued that, for taxpayers with a combined state plus federal tax rate of 45% or more, an HSA could be superior to a 401(k) with a 75% employer match.
Boost tax-free funds in retirement
One strategy that can be used to further leverage an HSA is to make an annual HSA contribution and then pay for medical expenses using existing cash flow. You can repeat this process each year and compile health care expenses indefinitely into the future. It is important to keep good records of your unused qualified medical expenses. In retirement, or at any age, you are then able to take tax-free distributions based on the total amount of expenses that you have accumulated over time.
Let’s further explore the ability to cash flow medical expenses despite having funds in an HSA to utilize. In the following comparison, Physician Phil has $10,000 of pre-tax income to allocate and retirement accounts are not an option because he has already reached his maximum contribution limits for the year.
In the first option, Phil puts $3,000 into an HSA, uses those funds to pay his health insurance deductible, and takes the remaining $7,000 as pre-tax income. At a 25% tax rate, this $7,000 eventually turns into take-home pay of $5,250.
On the other hand, if the HSA contribution is preserved in the account and medical expenses are paid out of pocket, Phil finishes with $3,000 in the HSA and $2,250 in a taxable brokerage or checking account. In the latter scenario, the net $5,250 is the same; however, Phil now has $3,000 in HSA funds that will grow tax-free, similar to a Roth IRA. Exercising the option to pay for health care expenses with existing assets and not tap into an HSA until later in life can offer an additional advantage to an already powerful tool.
Conclusion
Their triple tax advantage, spending and contribution flexibility, and year-end rollover of funds make HSAs an appealing option to accumulate savings for future health care expenses. Seek the help of a professional advisor with experience in financial modeling to help you integrate an HSA into your comprehensive retirement plan. The authors welcome your questions.
References:
- Geisler G. Could a health savings account be better than an employer-matched 401(k)? J Financial Planning. 2016;29(1):40-48.
- Wealth Planning for the Modern Physician and Wealth Management Made Simple are available free in print or by ebook download by texting HEALIO to 844-418-1212 or at www.ojmbookstore.com. Enter code HEALIO at checkout.
For more information:
David B. Mandell, JD, MBA, is an attorney and founder of the wealth management firm OJM Group www.ojmgroup.com, where Adam Braunscheidel is a wealth advisor. You should seek professional tax and legal advice before implementing any strategy discussed herein. The authors can be reached at mandell@ojmgroup.com or 877-656-4362.