Let's talk retirement accounts. Whether you work for an employer or yourself, you likely have access to more than one tax-advantaged account where you can save for retirement.
Some retirement accounts provide tax savings today, while others are designed to limit your future taxes. If you want both -- tax-deductible contributions now and tax-free withdrawals later -- you have only one option. It's called the Health Savings Account, or HSA, and it's the one retirement account I'd recommend to anyone.
You can save to an HSA only if you have a high-deductible health plan, or HDHP. The IRS defines HDHPs based on the plan's deductible and out-of-pocket maximums. The threshold values can change periodically, but they're as follows:
- In 2021 and 2022, HDHPs must have a minimum deductible of $1,400 for self-only coverage, or $2,800 for family coverage.
- In 2021, HDHPs must cap out-of-pocket expenses at $7,000 for individuals and $14,000 for families. The 2022 maximums are $7,050 for individuals and $14,100 for families.
If your HDHP is through your employer, you may be able to enroll in an HSA during your company's annual open-enrollment period. Your employer might offer an HDHP but no HSA, however. In that case, you can open an HSA with a financial company such as Fidelity.
Triple tax benefit
Here's what's most interesting about the HSA: It's the only retirement account that offers a triple tax benefit:
- HSA contributions are tax-deductible in the current year, up to the IRS limit.
- HSA investment earnings are tax-deferred.
- Any HSA withdrawals that pay for medical expenses (at any age) are tax free. Medical expenses can include coinsurance, copayments, dental work, vision care, chiropractic visits, prescriptions, and more.
Other HSA advantages
HSAs have more to offer beyond compelling tax perks, including:
- Free matching contributions. Some employers will match your HSA contributions. The matching formula may be less generous than your 401(k) match, but who cares? It's still free money.
- Portable funds. The money you put into your HSA is yours. If you leave your job, you take the funds with you. Note that you may have to forfeit employer-matching contributions if you're not fully vested.
- Investment options. HSA funds can and should be invested. Depending on where you hold your HSA, you might have access to a menu of funds or the full range of exchange-traded securities.
- No rollover restriction. There's no requirement to use up your HSA funds by the end of the year. You can roll over your balance indefinitely.
HSAs are powerful, but they're not perfect. They have disadvantages that can cost you money or prevent you from saving as much as you'd like. Four notable drawbacks of HSAs are the eligibility requirements, withdrawal penalties, low contribution limits, and potentially too much flexibility on withdrawals.
- Eligibility rules. You can't contribute to an HSA if you don't have an HDHP. You are also ineligible for contributions if you're covered by Medicare, Medicaid, or a spouse's health plan. This means you must stop contributing to your HSA when you enroll in Medicare -- usually at age 65. Any funds accumulated in your account at that time are still yours and can remain invested.
- Withdrawal penalties. Non-medical withdrawals from your HSA are always taxable. If you take a non-medical withdrawal before the age of 65, you'll pay a penalty on top of the tax.
- Low contribution limits. In 2022, you can contribute up to $3,650 to an HSA if you have an individual HDHP. If you have a family HDHP, you can contribute up to $7,300. If you're 55 or older, you can add $1,000 in catch-up contributions to those limits. These aren't huge numbers, even when you add in the catch-up contributions.
- Withdrawal flexibility. You can take tax-free withdrawals from your HSA at any age, as long as you use the money for healthcare. On one hand, that's an advantage. If you don't have cash available in your checking account for your contact lenses, for example, you can grab the money from your HSA.
That flexibility also adds complexity -- particularly if you're saving specifically for retirement. To build wealth in your HSA for healthcare expenses in retirement, you may have to forgo using your funds in the short term. Or you could estimate your short-term medical expenses, hold that amount in cash, and invest the rest. Unfortunately, that plan can easily go sideways if you're hit with an unexpected illness or injury.
HSA for now and later
Your HSA can save you money now with tax-deductible contributions and tax-free withdrawals for medical expenses. But this account really proves its worth when you use it to save for retirement. The tax-deferred investment earnings can help you grow a nice pot of money for your future healthcare expenses.
Also, the ability to take taxable, non-medical HSA distributions after 65 enhances the account's versatility. If you age well and don't need the funds exclusively for healthcare, you can use the money to backstop your 401(k) balance -- since 401(k) distributions are also taxable.
That means there's no risk of overfunding the HSA. Either you use tax-free distributions for medical costs or take taxable distributions for living expenses. It's one account, but it can play two different roles in your retirement finances. That versatility could turn out to make the difference in your retirement-readiness plan.
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