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Question: Our new health plan is HSA-compatible. I know these accounts are great to have in retirement, but it seems like such a hassle. We are not the most organized couple and I worry we won’t use it all. Is it worth it?
Answer: High-deductible health insurance plans can be wonderful for people who are generally healthy and don’t tend to see the doctor often. For people who tend to have frequent medical needs, they can be expensive.
But there’s a silver lining. If you’re enrolled in a high-deductible health insurance plan, you may be eligible to contribute to a health savings account, or HSA. And many financial experts are quick to point out that HSAs are a great tool to have on hand for retirement.
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That said, HSAs require good record-keeping. They also have strict rules. If you take a withdrawal for non-medical purposes, you’ll face taxes plus a 20% penalty (though the penalty is waived once you turn 65).
You may be wondering if an HSA is worth the hassle. Here’s why it may be, even for people who loathe paperwork.
HSAs offer tax breaks galore
The reason so many people use IRAs and 401(k)s to save for retirement is the tax benefits these accounts offer. Traditional IRAs and 401(k)s allow contributions to be made with pre-tax dollars. Roth IRAs and 401(k)s allow for tax-free gains and withdrawals.
But as Jeff Judge, CFP and Managing Partner at Chesapeake Financial Planners, likes to point out, with an HSA, you get all three.
“Contributions reduce taxable income, growth is tax-free, and qualified withdrawals are tax-free. No other account does all three,” he says.
Judge also likes to point out that HSAs are far superior to flexible spending accounts (FSAs).
“FSAs cap your contributions lower, expire at year-end or close to it, and aren’t portable when you leave your employer,” he explains. “An HSA is yours permanently, the balance carries over indefinitely, and you can invest it once the balance clears your plan’s threshold.”
“There’s really no risk of ending up with ‘too large’ an HSA balance.” — Jeff Judge
HSAs offer loads of flexibility
It’s true that HSA savers have to worry about penalties for non-medical withdrawals prior to age 65. But that aside, Judge says, these accounts are extremely flexible.
“You don’t have to reimburse yourself in the year the expense occurred,” he explains. “Reimbursements can be pulled years or decades later if the expense was qualified.”
That’s a big deal because HSAs grow tax-free. This means that if you incur a $1,000 medical expense now but can pay for it out of pocket, you can leave the money in your HSA and get reimbursed 20 years later, at which point that $1,000 is apt to be worth a lot more.
“I had a client who tracked medical receipts for 11 years in a simple folder on her computer, then pulled $23,000 in reimbursements tax-free in the year before retirement,” Judge says. “The IRS doesn’t require you to keep receipts in any particular format. They just need to be legible and show the date, provider, and amount.”
Judge also points out that after age 65, an HSA works like a traditional IRA for non-medical expenses in that you pay ordinary income tax on withdrawals but no penalty. In other words, there’s really no risk of ending up with “too large” an HSA balance.
Plus, as Judge points out, an average couple can expect to pay approximately $345,000 (after tax) to cover healthcare costs in retirement, according to Fidelity’s latest projections. Having a funded, tax-free bucket specifically for those costs is crucial.
Do HSAs hold up to inflation?
Of course, parking cash in an HSA for many years might seem like a bad idea, given that inflation could erode its purchasing power. Judge says that’s a legitimate concern.
“If the inflation-adjusted return on your HSA investments is negative, yes, the tax benefit can erode,” he says.
The key, therefore, is to invest your HSA strategically rather than keep your unused funds in cash.
“HSA funds invested in a diversified equity portfolio have historically outpaced medical cost inflation over long horizons,” says Judge. “The mistake isn’t treating the HSA as a long-term vehicle. The mistake is leaving the money in cash inside the account instead of investing it.”
Try not to treat your HSA as a checking account
Another HSA mistake you might make? Dipping in regularly when you have other options for covering medical expenses, says George Dimov, CPA and founder of Dimov Tax.
Dimov says that if you constantly take HSA withdrawals to pay for medical bills, it won’t function any differently than an FSA. And that greatly erodes the benefit.
Of course, tracking health care expenses can be a bit of a burden. But Dimov says it’s worth doing.
“The HSA is not about convenience,” he insists. “It is actually about doing the opposite of convenience. The whole strategy is paying bills out of pocket when you can afford to and letting the HSA grow.”
That said, developing an efficient tracking system could make the process easier. That could mean scanning receipts and storing records digitally or using an app. It pays to spend some time developing a system, making sure it’s backed up, and adding it to your digital estate plan.
Once you get into the habit of tracking HSA expenses, it may become less of a pain. And that way, you get to reap the benefits of tax-free growth on your money while legally shielding income from the IRS along the way.
