For today’s retirees, rising health care costs are a fact of life. The average 65-year-old couple is facing a lifetime total of over a quarter of a million dollars’ worth of premiums, prescription drugs and medical bills. There has never been a more critical time to save.
While 401(k)s, IRAs and annuities have plenty to offer, pre-retirees and middle-aged workers would be wise to consider health savings accounts. Underutilized but eminently useful, the HSA is a triple tax-advantaged way to provide for inevitable health care costs in retirement.
The Trade-Off: High-Deductible Health Coverage
With an HSA, contributions, growth and withdrawals for qualified medical expenses are all tax-free. Unlike 401(k)s and IRAs, HSAs also allow investors to withdraw at any time, again, provided that the funds are used to cover health care costs. Funds roll over year to year, the money can be moved between health plans or employers and relatives and other parties can contribute to the same account. Most HSAs even issue checks and debit cards, making it easy to pay for medications and other expenses at the point of sale.
What’s the catch?
“Investors have to have qualifying high-deductible health plans [to use HSAs],” said Richard Stone, Accredited Investment Fiduciary with The Lifetime Companies. “Almost everyone would open one if they could, but not everyone is eligible.”
For 2017, the minimum annual deductible for these HSA-accompanying plans is $1,300 for individuals and $2,600 for families. And while HDHPs are becoming more popular, many employers still offer the traditional higher-premium, lower deductible plans to which consumers have become accustomed.
“We serve about 220 employers, and probably 60 to 70 percent of them offer HSA plans,” added Stone.
For some savers, the cost differential isn’t worth a high deductible, either. Consider an employer who offers a choice between a traditional HMO with no deductible and an HSA-qualified plan with a $2,000 deductible. If the former plan featured a $200-per-month premium and the latter a $150 premium, an employee would essentially save $600 in exchange for a $2,000 risk. HSA plans allow employees to put away more, of course. But depending on their cash flow and priorities, the long-term savings may not be worth the short-term risks and opportunity costs.
Publication 969 lists HSA-qualified medical expenses, which include almost every health care-related cost a retiree might pay. Medical, dental and vision expenses are fair game, making it easier to fill the gaps left by Medicare Part B. Bills from chiropractors, physical therapists and other non-physician health care professionals also qualify – a welcome change for clients who’ve dealt with reimbursement runarounds. All prescription drugs qualify, as well, as do over-the-counter medications, with a doctor’s recommendation.
HSAs cannot, in general, be used to pay for health insurance; exceptions to this rule, however, get retirees off the hook. Long term care insurance and COBRA coverage qualify, as do Medicare Parts, A, B, D and Advantage premiums. And, once an employed investor turns 65, they can use their HSA to pay for their employer-sponsored health insurance. Medigap is not covered.
Limits, penalties and flexible growth
As of 2017, annual HSA contribution limits are $3,400 for individuals and $6,750 for families, and investors 55 and older can contribute an extra $1,000. While those limits pale in comparison with the 401(k) maximum contribution of $18,000, HSA dollars can grow at competitive same rates (not to mention tax-free).
“Most HSA plans have stock, bond and mutual fund investment options,” says Stone. “Some banks require you to stay in a money market up to a threshold, but once you exceed that, they let you set up a brokerage account within the HSA and invest it wherever you want, just like a 401(k).”
As for penalties, pre-retirement distributions taken for non-qualified expenses are taxable as income in full plus 20 percent. Once an investor turns 65, however, non-qualified distributions are taxed penalty-free, just like 401(k) distributions. Given the high likelihood of health care expenses both before and after retirement, however, smart savers can generally avoid these penalties and taxes altogether.
A winning strategy
What’s the best way for an investor to leverage an HSA?
“What we see people doing is contributing to their retirement plans up to their matching contributions,” said Stone. “If they want to save beyond that, though, they’re funding their HSAs to the max. It’s a better retirement funding vehicle, especially if you don’t have that employer match.”
Once these employees have maxed out their HSAs, only then do they continue contributing to their 401(k)s.
The HSA account type is also important; the best choice depends on a client’s age and retirement timeline.
“Younger clients should look into accounts that offer flexible investment features like mutual funds, stocks and bonds, instead of simply interest-bearing accounts,” said Charles Scott of Pelleton Capital Management. “Because the growth is tax-free and occurs over a long period of time, it could leave them with a significant balance to cover health care costs in retirement.”
Educating your clients
With so many benefits for the retirement-minded investor, why aren’t more people contributing to HSAs – and why is the 401(k) still the most popular savings vehicle? “Our experience has been that people just don’t know about them,” says Scott. “There’s nothing else that has that triple tax advantage, and if you have a high deductible plan, it’s a good option.”
Because they’ve only been around since 2004, HSAs aren’t as popular among retiring boomers, either.
“There really aren’t that many people in their 60s that have significant HSA balances because they haven’t had enough years to contribute,” said Stone. “Some people working now, though, are hoping to have $100,000 in their HSAs to use for retirement health care costs.”
Finally, a variety of misconceptions prevail about HSAs — most notably a confusion over the flexible spending account, which is, ironically, a less flexible option.
“Many people think they won’t be able to use the money at all if they don’t use it for health care, or that they’ll lose their funds if they don’t use them within a year,” said Scott. “This isn’t use it or lose it; it’s save it and keep it.”
Overall, an HSA may be an ideal option for your pre-retirement clients, particularly those who still have a decade or more to save. If you help them weigh the pros and cons, you can set them up for significant tax-free savings that will cover their health care costs more efficiently than a 401(k) or IRA.