The Health Savings Account: A Powerful but Oft-Overlooked Asset for Retirement

Some 15 years after the U.S. government established health savings accounts to give people a tax-favored vehicle to pay for medical and healthcare expenses, the HSA remains “the best deal in the tax code,” according to CERTIFIED FINANCIAL PLANNER™ professional and FPA member William M. Harris, co-founder of WH Cornerstone Investments in Duxbury, Mass.

That deal comes in the form of “a compelling mix of tax breaks and other savings that can keep [HSA account owners’] health insurance costs down,” explains FPA member Peter Lazaroff, CFP®, co-chief investment officer at Plancorp in St. Louis, Mo. “But under the right circumstances, these accounts offer an even more powerful — and largely underappreciated — chance to boost your long-term savings and provide a nest egg to offset the rising cost of health care later in life.”

Established as part of a federal tax law that took hold in 2004, HSAs are available to people who participate in a high-deductible health plan. The compelling mix to which Lazaroff refers begins with a triple tax advantage:

1. Contributions to an HSA net the contributor a current-year tax deduction (of up to $3,500 annually for an individual and $7,000 for a family in 2019).
   
   
2. Any earnings or growth in the value of funds in the account are tax-free.
   
   
3. Funds withdrawn from the account come out tax-free if they are withdrawn according to HSA rules and are used for qualified healthcare/medical expenses.

While those tax advantages certainly can be useful to the many people who contribute to an HSA and use funds in the account to pay healthcare and medical expenses on an ongoing basis, it’s the longer-term possibilities to which Lazaroff refers — the widely underappreciated aspects of the HSA — that make it a particularly appealing tool for people saving for retirement. Funds in an HSA can be used to cover qualified healthcare and medical expenses at any stage of a person’s life, including retirement, when they can be used to cover Medicare premiums, long-term care insurance premiums, long-term care expenses and day-to-day costs, from copays to prescription drugs to high-priced surgeries.

Those costs can add up over time, particularly during retirement, when people generally are more apt to need health care. According to Fidelity Investments, the average retired couple age 65 in 2019 may need about $285,000 saved (after tax) to cover healthcare and medical expenses in retirement. That figure is in today's dollars and excludes potentially expensive long-term care.

So rather than using the HSA mainly as a revolving account to cover qualified expenses in the short-term, there’s merit to the owner of the account instead using it as a long-term savings and investment vehicle, similar to an IRA (individual retirement account), contributing as much as they can to the HSA (up to the allowable yearly limit). Instead of using that money to cover near-term expenses over the course of a given year, they pay all or most of their medical/healthcare expenses out of pocket, thus leaving money in the account, where it can roll over from year to year, and where it has the opportunity not only to accumulate but to grow in value. To give HSA account owners access to upside potential, many HSA providers offer IRA-like mutual fund investment options in addition to a base savings account.

An HSA “can be treated as an IRA in that balances can roll from year to year, they can be invested in most any type of marketable security, and their annual contribution limits are substantially higher than an IRA,” explains James H. White, CFP®, who heads J.H. White Financial in Pottstown, PA.

That’s when an HSA becomes much more than just a tax-friendly revolving account and begins to function more like a long-term tax-favored retirement asset. Using such an approach, “You can walk into retirement with a nice, healthy pot of money to use for healthcare expenses,” says FPA member Cathy Gearig, a CERTIFIED FINANCIAL PLANNER™ professional with LifePlan Financial Advisory Group in Rochester Hills, Mich.

The longer the HSA owner follows that approach, the more time the money in their account has to grow. “If you begin maxing out [annual HSA contributions] at an early age, you can benefit from tax-free compound earnings for a long period of time, says FPA member Jake Northrup, CFP®, of Ballentine Partners in Boston, Mass. “This not only reduces your tax bill in the year of contributions, but creates a powerful investment vehicle that you can specially earmark for future medical expenses. With medical costs and life expectancy rising, this can be a very important strategy to utilize.”

Such a strategy works in large part because of the triple tax advantage associated with the HSA. Contributions, any growth inside the account, and distributions (withdrawals) from the account, when used for qualified medical/healthcare expenses, are all tax-free. “By investing your HSA savings as you would your retirement savings — typically in a diversified mix of mutual funds and [exchange traded funds] that offer the opportunity for long-term growth — you’ll build a tax-free fund dedicated to health costs in retirement, which are likely to represent a significant portion of your future budget,” says Lazaroff. “The chance to add another pool of tax-deferred money to your retirement savings is an advantage you shouldn’t ignore.”

Leading up to and during retirement, the funds inside an HSA always can be used, tax- and penalty-free, for medical/healthcare expenses. When the account holder hits age 65, the restrictions on how those funds can be spent lift, and HSA funds can be used for any purpose, without the account owner incurring a penalty (although they will have to pay income tax on distributions that aren’t used to cover medical/healthcare expenses). Also come age 65, account owners can use HSA money (again on a tax-free basis) to pay premiums on Medicare and certain kinds of insurance, such as long-term care insurance.

How much of that pool of HSA money a person decides to allocate to IRA-style equity investments (tied to the stock market, generally) and how much they opt to keep in a more conservative traditional fixed HSA vehicle depends on a person’s risk tolerance, and the extent to which they’re using the HSA not only as a long-term investment tool but also to cover near-term medical/healthcare expenses, notes Gearig. People who expect to pay near-term expenses out of the HSA may want to allocate more conservatively by keeping money in a savings-type HSA account, where it can’t lose value, knowing they may need to access that money soon, while also maintaining an investment portion of the HSA to access long-term growth potential, knowing the value of that investment allocation likely will fluctuate along with movements in equity markets. “It’s a good idea to treat the investment component of the HSA like you would funds in an IRA — more hands-off,” she advises.

As Gearig notes, not everyone has the cash flow required to both fund an HSA and cover all or most of their medical/healthcare expenses out of pocket. “That’s certainly not possible for everyone,” she says. “It really depends on the stage of life you’re in, and what you’re cash flow picture looks like.”

Regardless of the stage of life, it’s worth considering contributing to an HSA, and if cash flow permits, leaving at least some of those funds in the account as a long-term investment for retirement, because, as White points out, “Every dollar you can put in an HSA and save for retirement health care expenses will take some stress off of your other retirement accounts.”