If you had unlimited resources and access to a saving account with the following characteristics how much money would you attempt to save in an account that:

  1. You can contribute money on a pre-tax basis
  2. Then grow your contributions tax-deferred
  3. And finally, access the contributions and tax-deferred growth free from income tax?

What kind of savings account can check all of these boxes?

How about an IRA? Your contributions are made pre-tax. Check. They grow tax deferred. Check.  However, distributions are taxable as ordinary income. Nope! It’s not an IRA.

How about a Roth IRA? Your contributions grow tax deferred. Check.  Distributions come out income tax free. Check. However, a Roth IRA is funded with money that you have already paid taxes on. Nope! It’s not a Roth IRA.

So, What The Heck Is It?

Health savings accounts, or HSA’s for short, can check all of these boxes. They are funded with pre-tax contributions. Your contributions grow tax deferred. Finally, distributions are income tax-free so long as they are used to cover qualified medical expenses. Pretty neat, right?

An HSA may be a great way to sock away tax-deferred resources to be used to pay for qualified medical expenses throughout your retirement’s years.

Not to be confused with flexible spending accounts or FSA’s, which are pre-tax savings accounts that require you to use the balance of the account each year or else forfeit your money.

An HSA permits the perpetual deferral of your resources allowing you to build up the account year after year. Then you can use it to cover expenses you are inevitably going to face later in life, or reimburse yourself for qualified expenses already incurred. As long as the HSA was established before you incurred the medical expense, you can reimburse yourself for the expense years later.

Who Can Take Advantage of an HSA?

In order to qualify for an HSA you must be eligible. An eligible person is one who is covered under a high deductible health plan (HDHP).

A high deductible health plan for 2021 as defined by section 223(c)(2)(a) of the internal revenue code is:

A healthcare plan with an annual deductible that is not less than $1,400 for self-coverage or $2,800 for family coverage, and the annual out-of-pocket expenses (which includes deductibles, co-payments, and other amounts, but does not include premiums) do not exceed $7,000 per self only coverage or $14,000 coverage. (The minimum deductibles, and out of pocket limits are adjusted for inflation)

If you have access to an employer sponsored healthcare plan, often times but not always, you will have a health plan option that qualifies as a HDHP. You choose to elect coverage on yourself, also known as self-coverage, or if you have a family to cover you may elect what is known as family-coverage. The type of coverage you elect will determine how much you are allowed to contribute to your HSA on an annual basis.

For example, individuals can contribute $3,600 in 2021, up $50 from 2020. If you have family-coverage you can contribute $7,200 to you HSA in 2021, up $100 from 2020. Contribution limits are generally increased annually with inflation.

How Do I Fund My HSA?

Many folks choose to contribute to their HSA on a monthly basis. Specifically, those who have access to an HSA as a benefit through their employer will normally have automatic contributions deducted pre-tax from their paycheck. The employer may even make contributions as well.

However, if you have an HSA through a financial institution outside of your employer benefits package you may find yourself making after-tax contributions, and then deducting them against your taxable income when you file taxes next year. You can deduct these contributions even if you do not itemize.

You can even contribute to you HSA after then end of the year in order reduce your taxes from the previous year. For example, you can contribute to your HSA for 2021 after Jan. 1st 2022 up until the tax filing deadline of April 15 of 2022.

A Unique Funding Option: Qualified HSA Funding Distribution

There’s another unique way to fund your HSA using your existing IRA. Many folks are unaware that they are allowed to fund their HSA with dollars from their existing pre-tax traditional IRA (Note: SEP and SIMPLE IRAs may not be used directly, but you might be able to transfer your SEP of SIMPLE IRA to a traditional IRA first). You can actually take tax-deferred money from an IRA that would otherwise be taxable upon distribution as ordinary income, and use it to fund your HSA. Forever-taxed money becomes never-taxed money as long as it is used for qualified healthcare expenses. It’s called a Qualified HSA funding distribution.

You are permitted to do this one time in your lifetime up to the annual maximum contribution for the year. An individual could theoretically fund her HSA this year with $3,600 from her IRA, or she could fund their family coverage HSA with $7,200 from an IRA. The distribution must go directly from the IRA custodian to the HSA custodian. Any qualified distribution is not taxable, nor is it tax deductible, and it reduces the amount that can be contributed to your HSA for that year.

There is a caveat. You must meet the funding distribution – testing period. (https://www.irs.gov/publications/p969)

You must remain an eligible individual during the testing period. For a qualified HSA funding distribution, the testing period begins with the month in which the qualified HSA funding distribution is contributed and ends on the last day of the 12th month following that month. For example, if a qualified HSA funding distribution is contributed to your HSA on August 10, 2020, your testing period begins in August 2020, and ends on August 31, 2021.

No More Contributions After Enrolling in Medicare

You can contribute to an HSA after you are no longer working, but once you have enrolled in any part of Medicare you are no longer allowed to contribute to an HSA. That doesn’t mean you can’t contribute to your HSA in the year you enroll in Medicare.

In the year in which you transition to Medicare, you are permitted to make HSA contributions for each month in which you are eligible. In other words, if your Medicare eligibility begins in November, and you plan to transition to Medicare in November of this year, you can contribute to your HSA for the first 10 months of the year. In fact, you can wait until after the first of the year, and then make the contribution for the first 10 months when you file your taxes. Of course, it would be advisable to work with a tax professional to make certain you are following all of the IRS guidelines.

Beware, if you intend to file for Social Security prior to age 65 you’ll automatically be enrolled in Medicare part A when you turn 65. At that point, you will no longer be able to contribute to your HSA. Even if you’re still working, haven’t filed for Medicare Part B because you are eligible to remain on your employer’s qualified health plan, and would otherwise be eligible to contribute to an HAS, once you are automatically enrolled in Medicare part A you’re no longer eligible to contribute.

When and how to claim Social Security in order to optimize your benefits is a conversation for another day. In fact, we even wrote a book on the subject titled, You Paid, Now Collect: A High-Income Earner’s Guide To Optimizing Social Security Benefits. You can order a copy through our website or download an electronic copy at no cost.

HSA as a Retirement Account

An HSA does not have to be used while you’re employed. In fact, many folks choose to fund their HSA, but pay for their medical expenses out of pocket throughout their working years. Doing so allows their HSA contributions to be invested long-term and accumulate for later use to cover qualified medical expenses throughout retirement.

So, what are qualified medical expenses?

Qualified medical expenses are expense that would otherwise generally qualify for medical and dental expense deductions covered in IRS publication 502, Medical and Dental Expenses. Expenses incurred by you, your spouse, or your dependents are covered as qualified medical expenses for purposes of distributions from your HSA.

What’s not covered? 

Expenses incurred prior to the establishment of you HSA don’t count as qualified expenses. Neither do health insurance premiums generally speaking. For example, you cannot contribute to your HSA, and then turnaround and use the pre-tax contributions to pay for your health insurance premiums whether through your employer or otherwise.

However, premiums paid to cover COBRA, health insurance while receiving federal unemployment benefits, Medicare, or Long-Term Care insurance are all considered qualified medical expenses.

For example, you can use your HSA balance to pay for Medicare premiums Part B and D, and many other retirement-related medical expenses. You can even use your HSA to pay for long-term care insurance premiums to protect your family against the massive rising cost of care associated with Long Term Care event.

Tax Reduction Strategy

One of the advantages of growing your HSA, and using it for health-related expenses in retirement is to potentially reduce your effect tax rate. When HSA distributions are used for qualified healthcare expenses the distributions are not taxable.

On the other hand, if you were to use distributions from your IRA to cover the same healthcare expenses they would be taxable as ordinary income thus driving up your effective tax rate.

In addition to increasing your effective tax rate, distribution from your IRA can also negatively impact a percentage of your Social Security that is subject to tax. They also increase your modified adjusted gross income, and could result in Medicare premium surcharges known as IRMAA.

Medical expenses can easily make up 10% to 20% of your spending in retirement. By properly funding your HSA, growing it throughout your working years, and utilizing the accumulated balance to cover qualified medical expenses you may be able to lower your taxable income significantly.

Is an HSA Right for You?

An HSA can be a great way to save for your retirement years, but they may not be right for everyone. Whether you’re just starting out in your career, or nearing the transition from your working years your post working years it’s a good idea to reevaluate your relationship with your healthcare plan.  

Do you have access to a HDHP?  If so, it is a good fit for your family? If it is a good fit, should you fund your HSA or your IRA first if you have limited resources?  These are all good questions to think about. You don’t have to think through them on your own.

Consult your tax professional and ask your fee-based fiduciary financial advisor for guidance on how your decisions may impact you today, and into the future.

Perhaps looking at your HSA as a way to pay for current medical expenses may not be the most effective use of this unique planning instrument. Properly funding, and investing in your HSA with the intention of long-term tax-deferral followed by tax free withdrawals to pay for inevitable post-retirement medical expense is worth considering.  

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