How to Use a Health Savings Accounts to Save For Retirement

I’ve recently received a couple of emails from readers about Health Savings Accounts. One comes from Robert, who writes:

I would like you to cover HSAs in the future podcast. We just started using one, and we are getting confused and occasionally tripped up by some of the rules.

And a podcast listener named Patrick wrote in to say:

I have a show idea: using an HSA as an investment vehicle. I thought we had to pull all the funds out of an HSA by the end of the year, but that’s incorrect.

These emails spurred this podcast and blog post. We'll cover three questions:

What is an HSA (Health Savings Account)?
How can you use an HSA to save for retirement?
If you have limited funds, should you invest in an HSA or an IRA?

These are three basic questions about HSAs, and the answers may surprise you.

What is an HSA?

First, let’s talk about what an HSA is not. It’s not a Flexible Spending Arrangement or Flexible Spending Account as some call it. This is one thing that tripped me up, and it tends to confuse people. I, for one, have always used a Flexible Spending Arrangement (FSA), and didn’t, at first, know the difference between that and an HSA. But they are not the same thing.

With an FSA, you can put aside pre-tax money for certain qualified medical expenses. (You can also use FSAs for dependent care expenses, sometimes.) But, as you may know, you have to use all the money in your FSA by the end of the year, or you’ll forfeit it. The rules for FSAs have changed recently. In 2016, you can actually use your FSA money for some expenses incurred in early 2017 (until March 15, in fact). So that makes it a little more flexible. But, still, if you don’t use the money by the deadline, you lose it.

This makes an FSA tricky. When you decide at the beginning of the year how much to contribute for that year, you have to guess how much you'll spend on qualified expenses. You don't want to put too much aside and not use it. But if you're like most folks, you estimate on the conservative side so you don't lose any money. This is reasonable, but it also means you lose tax advantages if you end up spending more on qualified expenses than you put in your account.

An HSA is different. It's also tax-advantaged, which means you contribute pre-tax dollars to it just like you contribute pre-tax dollars to an FSA, a 401(k) or a deductible IRA. But there's a catch: an HSA is only available to taxpayers who are enrolled in a high-deductible health plan (HDHP).

See also: A Detailed Guide to HSAs

High Deductible Healthcare Plans

So what counts as a high-deductible health plan? Well, since the IRS has to answer that question, it's somewhat convoluted. They go through it in mind-numbing detail in IRS Publication 969. It's about as dense as can be, so I recommend reading it only if you need help falling asleep tonight.

But, we can sum it up easily enough. In 2016, for an individual, a high-deductible health plan is one with a deductible of at least $1,300. And if you have family coverage, your deductible in 2016 needs to be at least $2,600 to qualify. A family plan needs to meet both individual deductible and family deductible requirements, so you do need to be careful here.

If you’re close to the line or you’re not positive whether your current plan is a high-deductible health plan, ask your employer or your health insurance provider. If you’re buying on a healthcare exchange, the health insurance company you’re looking at can tell you whether or not each plan qualifies as an HDHP. In fact, the federal exchange, at least, will tell you right up front whether or not a plan qualifies for an HSA.

Bottom line: if you have a high-deductible health plan, you can contribute to an HSA.

HSA Contribution Limits

Just like with FSAs and tax-advantaged retirement accounts, HSAs come with contribution limits. These change from year to year, typically rising a bit with inflation.

For 2016, an individual can contribute up to $3,350 to an HSA. If you're on a family plan, your family can contribute up to $6,750. You don't have to contribute that much, but you can contribute up to that amount. And if you're 55 years or older, you qualify for a catch-up contribution of up to $1,000.

HSA Withdrawals

Now let’s talk about how you can use the money you contribute to an HSA. The main thing to know is this–as long as you use the funds you put into the HSA for qualified medical expenses, you can get the distributions tax-free. This gives an HSA a best-of-both-worlds advantage. It’s like a traditional retirement account where you contribute pre-tax dollars, and it’s like a Roth account at the back end where you get tax-free withdrawals. Of course, you only get the tax-free withdrawal when you’re using the money on qualified medical expenses.

One key benefit of HSAs is that you don’t have to use up all your HSA funds in the year you make the contributions. A Flexible Spending Arrangement has a use it or lose it provision, but HSA does not. This actually makes an HSA an ideal way to save for retirement, but we’ll come back to this point.

So what happens if you use the money in an HSA for something other than qualified medical expenses? You'll be taxed on the money, plus you could be hit with up to a 20% penalty in additional taxes. That's a little different than a 401(k) or an IRA, where you could get hit with taxes plus a 10% penalty.

If you put money into an HSA, you need to spend it only on qualified medical expenses. Once you reach 65, however, you can withdraw the money for any reason without paying the penalty. If you withdraw it after age 65 for medical expenses, you’ll still pay absolutely no taxes. If you withdraw the money after age 65 for any other reason, you’ll only pay income taxes on it – no penalties.

Before we move on, I have three bonus tips for you to check out:

Use an HSA Calculator

The first bonus tip is an HSA calculator, which you can find here. This calculator can help you work through your best option. Should you go with a high-deductible health plan paired with a Health Savings Account, or would you be better off with a lower deductible plan that doesn’t qualify for an HSA? It’s an easy calculator to work through and is great whether you’re single or have a family.

Choose Your HSA

The second tip is a tool to help you pick out an HSA. Even if your health insurance is through your employer, you can pick your own HSA company to manage your Health Savings Account. This is important because different administrators have different investing options.

Obviously, you want an administrator that has really good, low-cost investing options. You can use this tool – HSAsearch.com – to search for companies that will manage your HSA and to explore their investing options. It’s easy to compare the providers, and it gives you a ton of information, like monthly maintenance fees and investment options.

For instance, not all HSA providers offer mutual funds. That's exactly what I, personally, would want. So I'd immediately eliminate an HSA provider who didn't offer low-cost mutual fund options. But whatever your particular goals may be, the HSA Search tool can help you narrow down your choices.

See also: The Best HSA Accounts of 2022

Health Savings Administrators

I’ve not used them before, but one of the HSA providers I’ve come across is called Health Savings Administrators. I’ve never spoken with anyone from this company, but if I were to get a high-deductible plan, I would give a serious look at Health Savings Administrators.

You’ll see on their site that one of the navigation links goes to a list of funds they offer if you open an HSA with them. Again, I’m not endorsing this company. I’m just saying that they offer low-cost funds, so they’re one option for you to check out if you need someone to manage your HSA.

2. How can an HSA help you save for retirement?

You've probably already zeroed in on this as we've talked about what an HSA is and how it works. One component of an HSA that makes it a good retirement option is that you don't have to spend all the money in one year. If you spend less on qualified medical expenses than you contribute, you just roll the remaining money over to the next year. Over long periods of time, you can roll money over from year to year and make it part of your retirement savings.

Another component that makes HSAs a decent retirement savings option is that once you hit age 65, you can spend the money on things other than qualified medical expenses without being penalized. (Remember, you do have to pay income tax for non-medical withdrawals, though.) In this sense, an HSA is very much like a pre-tax 401(k) or deductible IRA. The only difference is that you have to wait until 65 to use the money penalty-free, rather than 59 1/2.

That being said, the age qualification is a downside. But once you hit 65, you could look to your HSA for some retirement income. And until then, you can use it as a tax-free way to pay medical expenses.

The third thing I like about an HSA as a retirement savings vehicle is that it doesn't limit what you can contribute to your 401(k) or your IRA. You can max out your 401(k) at $18,000 (ignoring the catch-up provision, for the moment). And if you can, depending on your income and work situation, you may be able to max out an IRA or a Roth IRA. But then you can still max out your contributions to an HSA.

In that sense, an HSA is a way to extend the amount of money you can put away for future medical expenses. But beyond that, the money in your HSA can act as income for your other retirement needs once you reach 65. So an HSA can augment what you're able to put away for retirement.

Should you fund an HSA before an IRA or 401(k)?

The third question we want to answer about HSAs is whether you should fund an HSA before an IRA or 401(k). If you can max both accounts, this question is irrelevant. If you have limited resources, however, it's a question worth considering.

Some people think you should fund an HSA before you fund an IRA. The theory is that you can use it for medical expenses, tax-free. And beyond that, it can still be a source of retirement income. So they think that since an HSA can be used completely tax-free for qualified medical expenses, it’s better to fund it first —before an IRA or 401(k). Dana Anspach, a Certified Financial Planner, has an excellent article on this very topic.

I don’t disagree with her approach, although there are some factors to consider before making this decision. Clearly, the advantage of an HSA is that tax-free spending can be applied now and at retirement. Without question, that’s a huge benefit.

But an HSA also has its disadvantages. For instance, if you need the money early, you'll have to pay a 20% penalty instead of the 10% penalty for an IRA or 401(k). And you have to wait all the way until age 65 (rather than 59 1/2) to avoid the penalty.

Where I come out is this: if you have limited funds and can't max out all these accounts, you certainly want to put aside money in an HSA (if you qualify for one) for at least the medical expenses you think you'll incur in that current year. That's just money you'll spend anyway, and it's a way to make those expenses pre-tax.

Then, I’d want to max out a 401(k) to the extent that I had an employer match. That’s just free money.

But beyond that, you could fund a little bit on the HSA, and finish off the 401(k) or an IRA — or do a combination. I like to do a little of both. But the bottom line here is that an HSA can be a great way to save for retirement.

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