Saving enough for retirement is a big issue for many Americans. As such, using all the tools available to savers is very advantageous. And one of the best and perhaps most underutilized is the Health Savings Account (HSA). Thanks to its variety of tax benefits, HSAs offer a unique way for investors to save for retirement.
The problem is they are often used incorrectly by investors. Most investors ignore their potential and keep their HSA assets in cash. But that truly is a losing strategy. Moreover, they forget to max out these accounts in favor of other retirement or savings vehicles.
For retirement success, using HSA first could be the best strategy for long-term wins.
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HSA Basics
Like many specialized savings accounts, HSAs were originally designed for a purpose. In this case, to help Americans save for current and near-term medical expenses. With the invention of high-deductible health plans (HDHPs), the accounts were created under the Medicare Modernization Act of 2003. This allowed Americans to save for their premiums and out-of-pocket expenses in a tax-efficient manner.
But like many accounts and savings vehicles, over time, we’ve discovered that many of the loop-holes and features can be used differently than directly intended. For HSAs, this comes down to various tax benefits. The accounts offer the trifecta of tax wins.
For starters, contributions to an HSA are tax deductible and many employers allow you to make the deposits with pre-tax money. As such, this reduces taxable income today and decreases the amount of money you need to send Uncle Sam in the current tax year. Secondly, these accounts allow savers to enjoy tax-deferred gains.
Interest, dividends and capital gains within an HSA are not subjected to taxes. This allows for tax-deferred/free compounding. Finally, HSA accounts allow for tax-free withdrawals when it comes to qualifying medical expenses.
This trio of benefits makes for a powerful combination for long-term growth.
Using Your HSA to Your Advantage
The problem is, the majority of people with HSAs don’t use them effectively to gain the most benefits. Part of that comes down to not maximizing their contributions to the account. Because of their health-focused nature, many people still use a 401(k) as their primary retirement vehicle rather than a health savings account. As such, most retirement contributions go into these accounts.
However, that is a losing strategy.
Like a 401(k), HSAs offer tax deduction today and tax-deferred compounding. However, 401(k)s lack the ability to have tax-free withdrawals. Pulling money out is subjected to ordinary income tax rates. An additional hit against 401(k)s, Uncle Sam will only compound tax-deferred for so long. With that, 401(k)s force you to begin withdrawing funds at a certain age – dubbed required minimum distributions (RMDs) – and pay taxes on those funds. This isn’t true with HSAs, and investors can leave funds in the accounts indefinity.
An added bonus to HSAs is that there is no time limit for medical expenses to occur. As long as you keep a record/receipt of your expenses, you can wait 10, 15 or even 30 years to pull the money out of your HSA account to get the tax-free withdrawal. So that means, if you pay a doctor’s bill today, you can wait until you’re retired to get reimbursed for that expense. And with many HSA plan sponsors now offering digital record-keeping of expenses, this becomes easy to ensure tax-free withdrawals later on.
And if you don’t happen to have receipts or medical expenses, HSAs have similar tax consequences to regular 401(k)s when making non-qualified withdrawals.
Adopt an HSA First Strategy
Given the current tax savings, tax-deferred gains and potential for tax-free withdrawals, many advisors now suggest what’s called an “HSA First” strategy. This is maximizing contributions to health savings accounts before contributing to a 401(k) or IRA. Right now, the IRS has set the maximum contribution limits for 2022 at $3,650 for individuals and $7,300 for families. The annual “catch-up” contribution amount for individuals age 55 or older is an extra $1,000. Investors should contribute the maximum here to take advantage of all the tax benefits. An offshoot to this would be to contribute just enough to get a 401(k) match then direct the rest into the HSA.
The next piece is making sure that you get the most out of long-term compounding of these HSA dollars. The default option for many health savings accounts is a cash account – often tied to a debit card. After meeting minimum requirements – often an account value of at least $2,000 – investors can choose various mutual funds and other ETFs to invest in. Some providers like Fidelity will even let you buy individual stocks. Using HSA funds as part of an overall asset allocation strategy is key.
Finally, keep and digitize all your receipts. Aside from hospital stays, doctor visits and prescription drugs, HSA dollars can be used for nearly anything health-related including over-the-counter medicines and first aid products. Having a record of all of this can help you pull money out of your HSA later on during retirement for tax free withdrawals.
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The Bottom Line
HSAs could be the ultimate retirement vehicle. Offering a trifecta of tax benefits, they could be the best savings vehicle around. And with that, investors need to max them out and invest them properly. Your future self will thank you.
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