Healthy Gains

James McGlynn

IT’S BEEN CALLED the stealth IRA. We’re talking here about health savings accounts, which offer a triple tax play. First, contributions are tax-deductible. Second, the accounts grow tax-deferred. Third, if the money is used to pay permitted medical expenses, there’s no tax on the sum withdrawn.

That might sound similar to an employer-sponsored flexible spending account for health care costs, but those are more restrictive. If much or all of the money isn’t spent by the end of the year, it’s forfeited. Think of health savings accounts (HSAs) as an improved version. Money in an HSA can be carried over indefinitely and the plan doesn’t cease with your job. Instead, the account stays with the employee—and, indeed, you don’t need to work for a large employer to set up an HSA.

To qualify for a health savings account, you must have insurance that’s classified as a high deductible health plan (HDHP). That’s defined as individual coverage with a deductible of $1,400 or above in 2021 or family coverage with a $2,800-plus deductible. The original intent of the HSA was to promote higher deductible plans, which should translate into both lower medical premiums and more thought before rushing off to see a doctor.

Oftentimes, employers will contribute to an HSA to lessen the risk that the accountholder can’t afford to pay the deductible. Even if your insurance plan has a $1,400-plus deductible, it’s a good idea to verify with the plan that it qualifies as an HDHP. My retiree medical plan originally didn’t qualify, but a few years ago the plan sent out a notice saying it now did, even though the deductible hadn’t changed.

The HSA contribution limits increased slightly in 2021. They’re $3,600 for an individual and $7,200 for a family, plus there’s a $1,000 catch-up contribution if you’re age 55 or above. You have until the mid-April tax filing deadline to make contributions for the prior year. This January, I contributed $4,600 to my HSA for 2021—the sum for an individual, plus my catch-up contribution—to get the account fully funded and invested early in the year.

My experience is with flex-spend accounts and employer-sponsored HSAs, both of which were easy to sign up for, thanks to my old employer’s benefits department. The good news is, even if your employer doesn’t offer HSAs, it’s possible as an individual to open an account at a brokerage firm or a bank. Many people who qualify for an HSA don’t have accounts, because their employer doesn’t offer them.

Where should you turn? Fidelity Investments recently eliminated fees for its HSA and it’s seen good investment performance, according to the researchers at Morningstar. Another highly ranked HSA is from fee-free Lively, which is affiliated with TD Ameritrade. My current HSA charges a $45 annual fee. I’m in the process of switching to Lively using a trustee-to-trustee rollover.

Health savings accounts are especially attractive for high tax-bracket workers since the deduction is worth more than it is for those with lower incomes. To be sure, if you aren’t paying medical expenses, HSA contributions aren’t immediately accessible tax-free, as they are with Roth contributions. Still, the list of qualifying medical expenses is quite exhaustive. You can use an HSA to cover your deductible, copays, prescription drugs, and vision and dental care. The account can also be used to pay Medicare Part B, C and D premiums. In addition, it can be used for long-term-care insurance premiums—within limits. An HSA, however, can’t be used for Medigap or health insurance premiums.

While HSAs are intended to cover current medical costs, I’d also view the account as a way to notch tax-free growth, which you might then use to pay for medical expenses in retirement. But to get the most out of the account, you need to invest for long-term growth, rather than stashing the money in low-yield or no-yield safe investments. To leave the account to grow, consider paying cash for current medical bills—but be sure to save your medical receipts. You can use those receipts later to withdraw the amount involved from your account, while getting tax-free growth in the meantime.

Health savings accounts get a little trickier once you’re in or near retirement. If you aren’t currently on Medicare, you can contribute to an HSA, assuming you qualify.  But once you’re on Medicare, funding an HSA can trigger taxes and penalties. The rules are tricky, as I explained in an earlier article.

Another important point: If the beneficiary of an inherited HSA isn’t your spouse, then the HSA will be fully taxable. There isn’t even a deferral period, as there is with an inherited IRA. That means a charity would be an excellent HSA beneficiary if you’re a single adult.

At age 61, my current plan is to contribute to my HSA until I turn 65. I keep some of the account in cash, but 80% or so is invested in the stock market. Once I turn 65, I may use the account to pay my Medicare and long-term-care insurance premiums, while leaving other accounts—notably my Roth IRA—to keep growing. The Roth account will be tax-free for my heirs and can continue to grow for 10 years after death. By contrast, the HSA would be immediately taxable to my children, so I plan to spend down that account first. An HSA has many virtues. Being a good inheritance isn’t one of them.

James McGlynn, CFA, RICP, is chief executive of Next Quarter Century LLC in Fort Worth, Texas, a firm focused on helping clients make smarter decisions about long-term-care insurance, Social Security and other retirement planning issues. He was a mutual fund manager for 30 years. James is the author of Retirement Planning Tips for Baby Boomers. Check out his earlier articles.

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