How a Health Savings Account (HSA) can be Used to Secure your Retirement
In September of 2012 astronauts were tasked with repairing a main switch on the International Space Station. When a bolt with damaged threads became stuck, the crew faced potential power loss. They would need to clean and lubricate the bolts to access the area. The solution? A simple electronic toothbrush. The hack worked, and the mission succeeded.[i] Sometimes alternative solutions are best.
For many Americans, the goal of saving for retirement may as well be the same as traveling to space. The statistics are sobering. “Fifty-two percent of U.S. households are at risk of running low on money during retirement,”[ii] warns The Wall Street Journal. Moreover, conventional methods like the 401K have proved woefully inadequate. The misconception that a 401K is a cure-all for retirement is so pervasive that even the original proponents of the plan regret their early work. “The great lie is that the 401(k) was capable of replacing the old system of pensions,”[iii] explained Herbert Whitehouse, a former human-resources executive at Johnson & Johnson. “It was oversold.”[iv]
Enter the Health Savings Account (HSA), an alternative solution to an unconventional problem. These accounts are designed to act as tax-advantaged medical saving accounts. The idea is that the account can benefit those who have a high-deductible health plan. The HSA holder can make contributions to the account without any income limits. If the plan does not cover an expensive healthcare invoice, the patient will still have a resource from which to pay. The plan is the ultimate triple play. First, all contributions to the plan are tax-deductible. Second, earnings are tax-free. Finally, withdraws used for medical expenses are tax-free.
If the HSA is for medical expenses why have some called it “The Stealth IRA”? The answer is simple: If upon reaching 65, you have remaining funds in the HSA the money can be withdrawn without penalty. In this scenario, you only pay income taxes. However, to start down this road, you must first enroll in a high-deductible health plan (HDHP) which means the deductible must reach $1,300 or more.[v]
An HSA is only as powerful as the investments within. Therefore, to realize the full potential of the solution the account owner must stay invested. It is wise to choose a diversified index fund to enjoy the benefits of compound growth. The diversity of equities mitigates risk while the low expense ratio structure keeps the erosion of costs in check. Be warned: If you withdraw funds before reaching 65 for non-medical expenses you will be subjected to income tax and a huge 20 percent penalty. If you withdraw cash after 65 for a non-medical expense, you pay only income tax (as is the case with a traditional IRA).
Why is the HSA a super-charged retirement vehicle? It offers the best aspects of traditional retirement accounts without any of the drawbacks. For example, with a 401K, 403B or Traditional IRA money enters tax-free. However, you will be taxed on the way out as you withdraw funds. A Roth IRA and Roth 401K offer no tax benefit upon contributing to the plan. The benefit comes when you withdraw the funds tax-free. In short: all of these accounts conform to the adage “Pay me now or pay me later.”
An HSA is different. There is no “pay me now,” and there is no “pay me later.” You are contributing tax-free dollars, benefiting from tax-free growth with tax-free withdraws.[vi]
The HSA may be the best-kept secret in retirement planning. If you choose to go this route consider maximizing your contributions with $3,400 annually for individuals and $6,750 for families (2017). The simplest way to commit to hitting the maximum is with regular payroll deductions. Automate for success. Some suggest leaving money invested in the HSA even when you do incur medical expenses. By staying in the stock market, you allow yourself the benefit of compound growth. If you keep your medical expenses carefully organized, you can reimburse yourself later once you've fully realized the magic of year-over-year growth. Essentially, the user stockpiles bills and receipts.
If you are facing a $2,000 expense and you choose to pay from the HSA, you will likely miss out on future earnings. For example, if the $2,000 stays invested for another ten years you will earn an additional $9,671 assuming an annual 7 percent growth rate. If you withdraw that amount to pay the bill, you incur not only the cost of the visit but the opportunity cost of share price appreciation. The idea is to leverage the power of the equities market. Capitalizing on compound growth is easy given that HSA funds roll over from one year to the next. Fees should remain a consideration. Most HSA plans include an account maintenance fee. However, in many cases, the cost is nominal and far outweighed by the ultimate value after years of growth.
HSA plans are relatively straightforward to use. Users can withdraw funds without obtaining approval from the HSA trustee or a medical insurance company. In fact, in many instances, the account holder can withdraw using a debit card or a check. However, qualifying medical expenses (e.g. co-pays, lab fees vision care, deductibles, and prescription drugs) must occur after opening the plan, not before.
Are there drawbacks? Yes, there are a few. Even the most organized people will find the task of managing an HSA challenging. A user may need to keep medical records safely tucked away for decades. If any of this information is lost, there is a real cost attached because you will not be able to harness the full tax savings that come from using medical expenses. This strategy comes from the simple fact that when Congress approved the HSA structure. The law says nothing of when the individual must execute the reimbursement.[vii] For this reason, consider digitizing receipts and keeping a backup log of tangible documents in the event of a hard drive crash.
HSA plans have been slow in connecting with the American public. However, in recent years more have learned of the benefits. Any American can open an HSA as long as they meet the following:
First, they must be covered by a high-deductible health plan. Second, they cannot be covered by another health plan. Third, they may not serve as a dependent on another person’s tax return. Finally, the individual must not be entitled to Medicare benefits. Even if you have a spouse that is covered by a different individual policy and you meet the above criteria you are still eligible to enroll in an HSA. That is, even if your spouse does not have a HDHP you may still qualify.[viii]
If you have the right plan you can either set it up through your employee benefits website or by using SelectAccount (no affiliation) to complete an application. Even if you lose your job, the HSA remains yours. If you elect to enroll in COBRA coverage you are permitted to pay the premiums from your HSA. Finally, note that if your spouse participates in an FSA, you may become ineligible if the FSA is used for your general health expenses.[i]
If you can stay organized and commit to regular contributions, an HSA is superior to nearly all other conventional retirement plans and fits perfectly within most people’s financial plans. If you want more information on how to take advantage of the “Secret IRA” reach out to a Phillip James advisor today!