When it comes to retirement income planning for most clients, less is not more, and the contribution limits placed on traditional tax-preferred retirement vehicles have many of these clients searching for creative ways to ensure a comfortable retirement income level. Enter the health savings account (HSA), which, though traditionally intended to function as a savings account earmarked for medical expenses, can actually function as a powerful retirement income planning vehicle for clients looking to supplement their retirement savings. For the strategy to work, however, it is important that your clients understand the rules of the game, and the potential penalties that can derail the substantial tax benefits that an HSA can offer.
The HSA income strategy
HSA funds are withdrawn tax-free if they are used to cover medical expenses, so clients can maximize the tax-preferred treatment of the HSA if the funds are eventually spent on qualified medical expenses. Despite this, there is actually no requirement that HSA funds be withdrawn for this purpose.
In fact, upon reaching age sixty-five, the client can withdraw the funds for any purpose without penalty. The income will be taxable as ordinary income, just as funds withdrawn from a traditional IRA are taxed. However, it is important for clients to understand that funds withdrawn to cover nonmedical expenses before the client reaches age sixty-five are subject to a 20 percent penalty in addition to the ordinary income tax rate that otherwise applies.
Because unused funds in the HSA never expire, your clients’ annual contributions can be left in the account to grow on a tax-deferred basis for years if the funds are not needed to cover medical expenses. As a result, many clients can accumulate substantial account balances that can serve to supplement traditional retirement savings vehicles.
Despite the fact that HSA funds can be used for any purpose after age sixty-five, most clients are actually likely to incur medical expenses on the road to retirement that can make tax-free withdrawals from an HSA an attractive option. These clients can still take advantage of the tax-deferred growth on the account value, however, because HSA funds do not have to be withdrawn in the year the expense was incurred in order to be withdrawn tax-free.
As a result, clients have the ability to contribute to the HSA, pay for medical expenses with after-tax dollars, and simply save the receipts and withdraw the HSA funds at some point in the future when the account balance may have grown considerably. As long as the client did not claim the medical expense as an itemized deduction on a prior tax return, the HSA funds can be withdrawn tax-free even years later.
Unless HSA funds are used to pay for qualified medical expenses by a surviving spouse, the funds are taxable income to the client’s beneficiaries.
HSA basics: Who can contribute?
In order to open an HSA, the client must be covered by a high-deductible health insurance plan (one with a deductible of at least $1,250 for self-only coverage or $2,500 for family coverage). In 2014, clients with self-only coverage can contribute up to $3,300 annually to an HSA (the limit is increased to $6,550 if the plan also covers the client’s spouse or other dependents).
Clients fifty-five or older are eligible to make an additional $1,000 catch-up contribution annually (each spouse is eligible to make a separate $1,000 catch-up contribution). When client begins receiving Medicare coverage, they are no longer eligible to contribute to the HSA.
HSAs can be a powerful retirement income planning tool for clients looking to supplement their income later in life — knowing the rules of the game, however, is critical to maximizing the value that these accounts have to offer.
For previous coverage of the use of HSAs in retirement planning in Advisor’s Journal, see Overlooked Postretirement Healthcare Strategy.
For in-depth analysis of the rules applicable to HSAs, see Advisor’s Main Library: Health Savings Accounts: 75 Tax FAQs.
Your questions and comments are always welcome. Please contact the Panel of Experts.