Don’t Overlook HSAs as a Retirement Savings Vehicle

One of the challenges to building a balanced financial strategy, which we call the “New Three-Legged Stool,” is getting money into the tax-free leg. This leg, which includes your Roth IRA and possibly a Roth 401(k), is crucial for creating tax-free income during retirement.

If you are contributing to a Roth IRA, however, you’re limited to $7,000 per year in 2024 ($8,000 if you’re over 50), and high-income earners may not even be allowed to make these contri­bu­tions. Roth 401(k) contri­bu­tions require an employer that offers the option, and then you contribute at the expense of being able to make after-tax contri­bu­tions. This may not be appealing to high-income earners.

There is another option for the tax-free leg that we encourage our clients to consider: the health savings account (HSA). HSAs must be paired with high-deductible health plans, and the maximum contri­bution in 2024 is $4,150 for individuals ($5,150 if you’re over age 55) or $8,300 if you have family coverage.

Here are the guidelines:

• Contri­bu­tions to an HSA are a top-line tax deduction. You don’t need to itemize them.
• HSA account balances grow on a tax-deferred basis.
• Withdrawals for eligible medical expenses are tax-free at any age. 
  • Withdrawals before age 65 for anything other than eligible medical expenses are subject to a 20% tax penalty and regular income tax.
  • After age 65, withdrawals are penalty-free for non-medical expenses, but you’ll still pay ordinary income tax on those distributions.

HSAs have a triple tax advantage:

• Contri­bu­tions are tax-deductible without an income limitation.
• Growth is tax-deferred within the account.
• Withdrawals are tax-free if spent on qualified medical expenses.

We recommend clients make the maximum HSA contri­bution each year and pay their medical expenses out of pocket but keep their receipts. The investment strategy for HSA funds is like one used for retirement accounts, typically involving a diver­sified portfolio of stocks and fixed invest­ments. This strategy allows the HSA balance to compound tax-free while you are still working. Then, in retirement, you can use your HSA balance to reimburse yourself tax-free for those earlier expenses.

Let’s consider the potential financial growth of HSA contri­bu­tions. If you invested $4,150 a year between ages 30 and 65, and your balance compounded at 8% annually, you’d have an HSA worth approx­i­mately $500,000. This substantial amount could be used to pay for Medicare premiums or prescription drugs entirely tax-free. You could also take tax-free withdrawals equiv­alent to prior years’ medical expenses, provided you saved receipts. This powerful strategy could signif­i­cantly boost your financial security in retirement.

Following this approach is common sense if you have the cash flow to cover medical costs while your account balance grows. However, it appears only 4% to 5% of HSA account owners max out their contri­bu­tions every year, even though some employers match contri­bu­tions.¹ Further, only 10% or fewer invest HSA balances in something other than cash. Most people use their HSA as a flexible health spending account and reimburse themselves for medical expenses as they go.

Not having enough income to pay medical expenses while making the maximum contri­bution could be a reason for the low imple­men­tation. Yet even many high earners use their HSAs as debit accounts to pay medical bills. Few account owners seem to be disci­plined or informed enough to max out HSA contri­bu­tions and leave them alone to grow.

Additionally, this strategy requires the combo of a high-deductible plan and an HSA, where the HSA provides access to long-term invest­ments rather than just a deposit account. Employees usually get an HSA through a bank or brokerage that has partnered with their company. Smaller banks and credit unions offering HSAs typically provide money-market accounts and perhaps a CD (certificate of deposit) option. Investment options typically depend on the employer, with some employers offering a menu of two or three dozen mutual funds.

If your employer-sponsored HSA lacks investment options, consider moving the funds to a personal HSA. While your employer might make it easy for you to open an HSA with a particular admin­is­trator, you can choose where to put your money. An HSA is not as restrictive as an employer-sponsored retirement account, such as a 401(k) or 403(b); it’s more like an IRA. This flexi­bility allows you to tailor your investment strategy to your specific needs and goals.

Moving HSA funds is a straight­forward process, like an IRA rollover. If done correctly, it won’t incur taxes or penalties. You will need to check if your employer-sponsored HSA allows free transfers or if there is a cost to move funds each time. Some employers match contri­bu­tions dollar-for-dollar up to a certain amount, so it’s worth checking if the transfer impacts matching.

The next step is to open a personal HSA account. Once funds are deposited into your employer-sponsored HSA via payroll, you’ll move them to your personal HSA. You likely won’t be paying FICA taxes when you make HSA contri­bu­tions directly through payroll, which is why contri­bu­tions should go into the employer-sponsored HSA first. Directly contributing to a personal HSA is the least preferable method.

Americans have saved nearly $14 trillion in Roth IRAs.² Investors are attracted by their double tax-free treatment: after-tax contri­bu­tions grow tax-deferred, and qualified withdrawals are tax-free. However, the triple tax advantage of HSA accounts has been largely overlooked as an investment tool. HSAs provide an excellent way to save, invest, and take distri­b­u­tions without paying taxes.

Insights:

• Health Savings Accounts offer a triple tax advantage.
• HSA accounts are not as restrictive as 401(k)s. Funds can be moved at any time.
• Money in an HSA that doesn’t have investment options can be moved to a personal HSA that does.