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An Underrated Retirement Savings Vehicle: The Health Savings Account

The HSA’s Unique Power

Why use an HSA for retirement? Shouldn’t HSAs be used to pay for medical expenses when they arise? And aren’t there already 401(k)’s and IRAs explicitly designed for retirement saving? In short, the HSA’s most significant property is that it’s the only investment account with the triple threat: tax-deductible contributions, tax-exempt growth, and tax-free withdrawals.

In order to fully appreciate the significance of the triple threat, it's important to take into account the impact of taxes. While it's obvious that taxes reduce the amount of money you get to keep, what may not be so clear is how much of an impact taxation can have when compounded over time. To illustrate this point, consider the following thought experiments.

Comparing Potential Growth Across Retirement Savings Accounts

Consider a couple currently in the 22% marginal tax bracket while working, whose investment returns are 8% annually and taxable at 15%, and who will be in the 24% marginal tax bracket at retirement. They have $10,000 of pre-tax money they’d like to invest and don’t anticipate withdrawing it until 30 years later in retirement. They would like to know what lump sum they could take home after tax in 30 years, if those assumptions hold, by investing in the various possible accounts.

Taxable Brokerage Account

First, we can calculate the returns on a taxable brokerage account. It does not allow for a tax deduction at initial investment, has taxable investment returns, and has tax-free withdrawals. In 30 years, the taxable brokerage account would provide the couple $56,135 in their pocket, ready to spend.

Roth IRA

Next, we can calculate the returns in a Roth IRA account. Roth accounts also have no tax deductions for the initial contribution and, under the conditions laid out in this scenario, have tax-free distributions. In contrast to a taxable account, though, its investment returns are tax-free. In this scenario, $10,000 would grow to $78,488 in a Roth IRA account. Quite an improvement over the taxable account!

Traditional IRA

We can also calculate the return on a traditional retirement account, such as a traditional IRA (the type of account usually referred to when one says an IRA). In some ways, traditional retirement accounts are the inverse of Roth accounts. While both have tax-free investment returns, the traditional account has its tax deduction upfront when contributing, at the expense of its withdrawals being taxable. Continuing with the same scenario, a traditional IRA account’s final after-tax lump sum is $76,476.

As a side note, this is slightly less than the Roth account’s final number. That is because the marginal tax bracket at retirement is higher than the current marginal tax bracket. Mathematically, suppose an investor’s tax bracket is the same at contribution time as at distribution. In that case, the final take-home amounts will be equal, whether the investment is in a traditional or Roth account. The differences come from having different tax brackets at different times. Anticipating an investor’s tax brackets, both now and in the future, is essential to financial planning.

HSA Growth Potential

Finally, we can calculate the HSA's growth in the scenario under consideration. As explained above, HSA accounts have tax-deductible contributions, tax-exempt growth, and tax-free withdrawals. Therefore, the initial investment would grow to $100,627.

That is a significantly larger after-tax sum than what the retirement accounts, not to mention the taxable account, would achieve. Illustrated below for comparison, here is what the various accounts would grow to in the hypothetical couple’s (not unusual) situation:

HSA Requirements

The HSA’s tax advantages make it an attractive investment vehicle. Should people pour their entire life savings into one? Not quite. There are numerous rules and regulations governing the use of HSAs. For one, an investor has to be eligible to open one by meeting the following conditions: [Health Savings Account (HSA) Rules and Limits (investopedia.com) FAQs for High Deductible Health Plans, HSA, and HRA (opm.gov)]

They are covered under a qualifying high-deductible health plan (HDHP), which meets the minimum deductible ($1,500 for individuals and $3,000 for families in 2023) and the maximum out-of-pocket threshold ($7,500 for individuals and $15,000 for families in 2023) for the year.
They are not covered by any other medical plan, such as a spouse’s plan.
They are not enrolled in Medicare.
They are not enrolled in TRICARE or TRICARE for Life.
They are not claimed as dependent on someone else’s tax return.
They have not used Veterans Administration medical benefits in the past three months (exceptions apply to veterans enrolled in a high-deductible health plan who either have a service-connected disability or have only accessed disregarded coverage and preventative services in the past three months).
They do not have any disqualifying alternative medical savings accounts, like a Flexible Spending Account or Health Reimbursement Account.

Aside from eligibility concerns, a potential investor should also consider the following rules:

There are maximum contribution amounts. For the 2023 tax year, they are $3,850 for individuals and $7,750 for families.
Investors 55 and older can contribute up to an additional $1,000 per year as catch-up contributions.
HSAs don’t have any use-it-or-lose-i it provisions. Any funds still in the plan at the end of the year can be rolled over indefinitely.
When an HSA holder’s spouse is the beneficiary of the account holder’s HSA, the account passes on to the spouse as their own HSA when the original account holder dies. [Inherited HSA Rules — Oblivious Investor]
If someone other than a spouse is the beneficiary of an HSA, the account ceases to be an HSA at the original account holder’s death. Instead, it becomes a regular taxable account, and the full value of the account is taxable as income to the beneficiary in the year of death.
If an HSA holder’s estate is the beneficiary of their HSA, the account ceases to be an HSA at the account holder’s death, and the value of the account is included as income on the decedent’s final tax return.

HSA Intended Use

The most important feature of HSAs is that they are meant to be used for qualified medical expenses incurred by the account holder, their spouse, and their dependents. These qualified medical expenses are identified in IRS publication 502 and include payments for diagnostics, cures, mitigations, treatments, prescribed preventative medications, doctor visits, lab tests, hospital stays, and medical transportation (such as ambulance services). Your HSA can also be used for dental expenses and vision care. Many other things may be covered, like acupuncture, contact lens solution, smoking-cessation programs, or service animal adoption. In addition, some others are not applicable to your HSA, like cosmetic surgery, maternity clothes, and childcare for healthy children. [What Can I Use My HSA For? - Workest (zenefits.com)] It’s critical to avoid non-qualified withdrawals. If you use your HSA for non-medical or non-qualified withdrawals, they are subject to income tax. For account holders under 65, those non-qualified withdrawals will come with an additional 20% tax penalty.

HSA Drawbacks and How to Limit Them

The above rules show the downsides and limitations of investing in an HSA account. Some drawbacks can be mitigated, while others may force an investor to avoid HSAs entirely. There are two primary drawbacks to an HSA.

HSAs Can Only Be Spent on Qualified Medical Expenses

HSAs are only helpful when paying for qualified medical expenses. While that is undoubtedly something to be concerned about, medical expenses are typically a significant component of retirement expenses; an investor who is as healthy as a horse in their working years should know that there is no guarantee that they will continue to be healthy in their retirement years. If you are still apprehensive about possibly saving beyond what is needed for future medical expenses, there are two major ways to mitigate that risk. First, although there's already a limit in place for how much can be saved each year, you can reduce your savings to be even further below the limit. Second, you can spend some of your savings each year as expenses arise. If you play your cards right, you can save on medical expenses now and reserve for medical expenses in retirement.

Qualifying for An HSA Requires an HDHP

Another major issue is that to qualify for an HSA, you have to be enrolled in a high-deductible health plan (HDHP). While these plans are optimal for some workers, they are certainly not for others, who may pass up on an HSA due to the need for another type of health plan. However, if the cost-benefit analysis between an HDHP (and its concurrent HSA) and another health plan is close, high-income earners may consider “self-insuring” possible larger expenses under an HDHP because of the potential tax benefits they’d reap from an HSA. This is another area of personal finance where deeper analysis can pay dividends.

HSAs: Enrolling and Using Your Savings

If, after careful deliberation, an investor determines that an HSA makes financial sense for them, what next? How do you sign up for an HSA? And what’s it like to actually use your HSA?

The first step to getting an HSA is to enroll in an HDHP. If that is done, their human resources department should be able to help them set up an associated HSA, assuming one is available. If one is not available with the HDHP, the investor can set up their own. Banks, credit unions, and brokerages all offer HSAs. Some pay attractive interest rates, while others allow for investments in stocks, bonds, and mutual funds. All that is usually required to set one up is a relatively straightforward application with information on the HDHP. After the account is set up, it can conveniently pay for qualified expenses with a debit card or checks. A word of caution, however. There is a penalty for using HSA money on non-qualified expenses. Even if an expense is unqualified, the transaction will still process; it will just result in taxes and, if the account holder is under 65, the penalty mentioned above, as well.

HSAs, The Bottom Line

HSAs offer a uniquely potent investment opportunity. They are the only accounts with triple taxation benefits – benefits that are even greater than they appear at first glance. Accompanying these benefits are a few stipulations and possible drawbacks, many of which, however, can be planned around. These easy-to-use accounts are, therefore, a key component of many investors’ financial plans. For further considerations about HSAs and how they can be applied in particular situations, one may reach out to a CERTIFIED FINANCIAL PLANNER™ practitioner.

Author: Corey Palko, CFA, CFP® | Allegheny Financial Group | August 2023

The information included herein was obtained from sources which we believe reliable. This report is being provided for informational purposes only. It does not represent any specific investment and is not intended to be an offer of sale of any kind. Past performance is not a guarantee of future results.

Allegheny Financial Group is a Registered Investment Advisor. Securities offered through Allegheny Investments, LTD, a registered Broker/Dealer. Member FINRA/SIPC.

An Underrated Retirement Savings Vehicle: The Health Savings Account

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The HSA’s Unique Power