Tax Free Retirement Investing with Your Health Savings Account

Several years ago, my employer switched our group health insurance to a high deductible plan with a Health Savings Accounts (HSA).  Unless and until the Obama administration manages to totally revamp our health care system on a national scale, I suspect that many baby boomers will be introduced to the Health Savings Account in their workplaces as well.

If you are not familiar with Health Savings Accounts, the simplified explanation goes like this. First, the deductible on the underlying group health insurance must be increased.  Typically, the deductible is in the $2500-$5000 range for family coverage.  Each employee in the insurance plan is then provided with an individual Health Savings Account.  The employer and/or employee can contribute the HSA each year, up to a maximum yearly amount set by law.   The maximum contribution (the total of employer and employee contributions) allowed in 2008 was $5650 for a family plan.  If the employee is over 55, that employee can contribute an additional $900.  All of the HSA contributions are excluded from taxable income on your IRS Form 1040.

In most plans, the HSA funds are held by a plan administrator and can be invested for long term growth.  The investment options can vary from plan to plan, just like for a 401(k) account.  This makes the Health Savings Account similar to a deductible IRA because all of the money goes into the account on a tax-free basis. It’s actually better than a standard IRA because it can go hand-in-hand with a qualified retirement plan, regardless of the employee’s income.

The employee can withdraw funds from the HSA to pay for (or reimburse) a wide variety of qualified medical expenses, including most over-the-counter type expenses not covered by insurance.  As long as you follow the rules on which expenses are reimbursable, no taxes are paid on withdrawals, including on investment gains from the HSA.  This feature makes the Health Savings Account similar to a Roth IRA in which all withdrawals from the account are tax-free. Note again that the HSA is actually better than a Roth IRA because there are no income limits on eligibility.  For example, my income disqualifies me from opening a Roth IRA but I have no such problem with using a Health Savings Account to invest.

When we first started using our HSA, I followed conventional wisdom and used HSA funds to reimburse all of our medical expenses, including expenses not covered by our insurance plan.  I then realized that I was missing out on a golden opportunity to use my Health Savings Account as a completely tax free retirement investment account. I determined that I would probably do better in the long run by not spending any HSA funds now.   Instead, I could let them accumulate in my account, keep them invested, and withdraw the HSA funds when I retire (including investment earnings) without paying any taxes.  In other words, my Health Savings Account would in effect become a “double Roth” type investment account, because no taxes are paid either on money going into the account or coming out.   To my knowledge, there is no other legal investment option that gives you that advantage.

So that we can take money out of my HSA tax-free, we need to save all of our receipts for every qualified medical expense we incur and put them in a file. We have been doing this for two years, including receipts for things such as aspirin, ointments, eyeglasses, dental bills, etc., that insurance does not cover, along with all of the typical physician bills and prescriptions that insurance did not pay because they were under the deductible.  We will save these receipts until we need tax free income in retirement.  According to IRS regulations, you are allowed to withdraw Health Savings Account funds that have accumulated (and grown) over many years and apply them to un-reimbursed qualified medical expenses that were incurred in past years. You just need to be sure that the expenses were incurred after your Health Savings Account was set up.   So, if I want to withdraw $2500 in income (tax free) in 2020, I can withdraw $2500 from my HSA and match that money with $2500 in receipts from our paper file.  Because we will have already paid those old bills, we will be able to use the $2500 withdrawal in 2020 for anything we want, tax free.

A key point and assumption is that the Health Savings Account should eventually have accumulated investment earnings.  When I turn 65, I can also use HSA funds to pay Medicare premiums.  Medicare premiums are increasing at a rate that exceeds the rate of inflation.  HSA funds cannot be used to pay conventional health insurance premiums now (or for Medigap coverage when I retire).  However, the IRS will allow you to use HSA funds for Medicare premiums and for certain types of long-term care insurance.  I will use accumulated investment earnings in the Health Savings Account to pay those expenses, again tax free.  Even if I want to use HSA funds for non-medical expenses, that is permitted without penalty after age 65, paying ordinary tax rates on withdrawals for non-medical expenses.

I recommend that before adopting this tax free investment strategy with your Health Savings Account, be sure that you have decent investment options for your HSA contributions. If you are limited to a money-market type of account, that may not justify delaying use of ypur HSA funds.  I was able to select a balanced stock-bond mutual fund for my HSA funds.  I hope it will have 6%-8% annual tax free growth over the next 10 years.  If my hope is fulfilled, our Health Savings Account will provide additional flexibility in managing the tax burden associated with future withdrawals of retirement assets in the future.

Photo credit:  Thomas Picard

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