Triple Play

Richard Connor

I’M A BIG FAN OF health savings accounts, or HSAs. They’re becoming more popular as a way to pay for medical costs—and, in the right circumstances, they can also be a valuable addition to your retirement plan.

What’s so great about HSAs? If used properly, they’re triple tax-favored. You get a tax deduction when you deposit funds. The growth thereafter is tax-deferred. And if you use distributions to pay for qualified medical expenses, withdrawals are tax-free. Result? There’s a saying that HSA funds “go in like a traditional 401(k) and come out like a Roth.”

An important feature of HSAs: The money is yours forever. You can accumulate it year after year, unlike a flexible spending account for health care expenses, which has to be largely or entirely emptied each year. There’s also no time limit for using the funds to pay for qualified medical expenses. As long as you have proper documentation, you can get distributions at any time in the future—and those distributions will be tax-free, even if the medical expenses were incurred years earlier.

The upshot: You can use an HSA as another retirement savings vehicle. Think of the strategy as having two phases: an accumulation phase and a decumulation phase. In the accumulation phase, you’re not only amassing funds in the account, but also accumulating medical expenses for later reimbursement. In the decumulation phase, you submit prior expenses and get reimbursed tax-free from your HSA.

Let’s say you have 10 years to retirement, and you have enough income to both fund an HSA and pay medical expenses out of pocket. Each year, you fund the account up to the IRS maximum and invest for long-run growth. You also save your medical receipts each year. You do this for the 10 years leading up to retirement, building up both a nice sum and a pile of medical receipts.

At retirement, you start the decumulation phase. You take the saved medical receipts and “cash them in” against your HSA account balance. As long as the expenses were for qualified medical expenses, the distribution is tax-free. Note there are no required minimum distributions for an HSA, unlike most retirement accounts. A key caveat: Although you can wait years to be reimbursed for a medical expense, the expense must have been incurred after the account was established.

Sounds easy? Don’t underestimate the record keeping that’s involved. IRS Publication 969 says you must keep records sufficient to show that:

  • The distributions were exclusively to cover qualified medical expenses
  • The qualified medical expenses hadn’t been previously covered by the HSA or another source, such as your health insurance company; and
  • The medical expenses hadn’t been claimed as an itemized deduction in any year on your federal tax return.

What if you’re ever audited? Each account holder is responsible for maintaining all records associated with their HSA for tax purposes. Experts recommend keeping receipts for three-to-seven years after you’re reimbursed by the account.

I’ve found that, to maintain multiple years of receipts, you need a well-organized, easy-to-use system. You can do this yourself with folders for each year. Alternatively, you might scan receipts and save them on digital media for future uploading to your HSA account. This is how I started. Luckily, the technology and sophistication of HSA accounts are making this easier. Some HSA providers have the capability to maintain a digital paper trail of your HSA spending by capturing and uploading images, even allowing users to add notes and organize receipts into folders.

Once you have your receipts saved, you can cash them in as desired. I’m aiming to hold off until my wife retires and we need the income. I am, however, worried that the amount of data will get too great and become hard to manage. I also worry that, if I’m not around, it would be a burden for my wife. Given these concerns, I’m considering some “harvesting” strategies, such as withdrawing a past year’s medical expenses each year in retirement or perhaps two years of expenses every other year.

What if you don’t have enough medical expenses to use up your HSA balance? You might use the funds to pay for a long-term-care policy. After age 65, HSA funds can be used to pay Medicare Part B, Part D and Medicare Advantage premiums (but not, alas, for a Medigap policy). You can also use the funds to pay for COBRA benefits.

After age 65, HSA distributions can be made from an HSA for non-medical expenses. These distributions will be taxed as ordinary income, just like withdrawals from a traditional IRA. What if you make withdrawals for non-medical expenses before age 65? You’ll get hit not only with income taxes, but also a 20% tax penalty.

Richard Connor is a semi-retired aerospace engineer with a keen interest in finance. Rick enjoys a wide variety of other interests, including chasing grandkids, space, sports, travel, winemaking and reading. His previous articles include Read the Fine Print, Return on Investment and Decision Time. Follow Rick on Twitter @RConnor609.

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R Quinn
R Quinn
3 years ago

Good points all, but the sad truth is that HSAs are unrealistic for moderate and low income workers. A recent study from Lively, Inc showed 96% of the HSA funds were spent on routine care in the year the funds were put in the HSA. In other words, the real long-term value may be non-existent by choice or circumstances. Logical or not, people simply do not want to divert money from spending on anything to pay even a modest health care bill. The HSA is great in theory, but for most Americans trying to pay premiums, contribute to the HSA and pay OOP costs to preserve the HSA while presumably saving for retirement is virtually impossible.

R Quinn
R Quinn
3 years ago

One of the problems is that many employers have HDHP where the deductible far exceeds the IRS requirement and that is a burden for many average workers. I agree that if workers took the premium savings and out them in the HSA most would be better off, but they just don’t think that way.

james mcglynn
james mcglynn
3 years ago

Another reason to begin to spend the HSA besides the complications for the spouse is that even though the HSA can be inherited by the spouse with no tax consequences, upon her death the account will be fully taxable immediately to the heirs. No stretch or 10 year time frame. Great article.

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