Health savings accounts (HSAs) are tax-advantaged medical savings accounts designed to help people cover the out-of-pocket costs they incur while enrolled in a high-deductible health plan (HDHP). Despite HSAs being designed to help people manage medical expenses, their structure and tax benefits make them a useful tool for retirement savings as well.
If you have an HDHP and open an HSA, the funds have a threefold tax advantage. First, the funds can be withheld from your paycheck, or you can make deductions yourself. That’s where the first tax advantage comes in. Either the deposited funds are made with pretax dollars, or you can deduct your contributions.
The second tax advantage is that the money in the account grows tax free, similar to funds within a 401(k) or an IRA. Third, your withdrawals are not taxed, provided that you are using the money for qualified medical expenses. You can find all the details about which expenses qualify on the Internal Revenue Service (IRS) website at https://www.irs.gov/publications/p969/ar02.html#en_US_2016_publink1000204081.
“If you receive distributions for other reasons, the amount you withdraw will be subject to income tax and may be subject to an additional 20 percent tax,” states the IRS.
One potential reason more people don’t take advantage of this great tax-advantaged program is because they confuse it with a flexible spending account (FSA). With an FSA, if there are funds left over at the end of the year, they might not roll over to the next year, although some plans allow a set amount to roll over. Unused funds within an HSA, on the other hand, roll over in their entirety.
The ability to roll funds over makes plain why an HSA is such a great tool for saving on medical costs, but it still doesn’t explain why so many people recommend HSAs as retirement savings tools. The reason for that is the added penalty for withdrawing funds for non-qualifying expenses goes away after you reach the age of 65. Once you reach age 65, the money can be withdrawn for non-medical expenses and taxed as income, which is similar to how withdrawals from an IRA are treated.
“Because HSA rules allow funds to carryover indefinitely with the triple tax-free benefit of funds going in tax-free, growing tax-free and coming out tax-free for qualified medical expenses, I have yet to find a reason that someone wouldn’t choose to max out their HSA before funding their 401(k) or other retirement account beyond their employer’s match,” states Forbes contributor Kelley Long.
Another attractive feature of an HSA is the ability to keep the funds in mutual funds or other investments. This depends upon how it is set up initially, so if your priority is to invest in mutual funds, make sure you do your research and read the fine print beforehand. Your financial institution can help you compare all of your retirement savings and investment opportunities so you can come up with the best plan of action.