Editors' pick: Originally published Dec. 2.
A health savings account is a tax-advantaged savings vehicle that can be highly useful for anyone who is saving for retirement. That is especially true if you have already maxed out your current annual contribution to an IRA or 401(k).
Uniquely, HSA deductions are triple tax-free. First, funds socked into an HSA are tax-deductible. Second, earnings are tax-free. And third, so are withdrawals to pay for qualified medical expenses.
"HSAs can be a great way for people to sock away additional retirement savings in the most tax-advantaged way that there is," says Marcy Keckler, a vice president for Ameriprise Financial in Minneapolis. "They really are triple tax-free."
Most people use HSAs to pay for current medical expenses. However, HSAs can also be used to build up significant amounts to pay for medical care after retirement. That's more important than you might think, says Barbara Delaney, founder of StoneStreet Advisor Group, a financial planning firm in Pearl River, N.Y.
"When you retire, Medicare doesn't cover a lot of costs," Delaney says. "You're going to be out of pocket a lot for healthcare." In fact, she says, the average retired couple will spend over $250,000 out of pocket for health care costs not covered by Medicare or supplemental insurance.
HSAs aren't for everyone or every purpose. To start with, they are only available to people with high-deductible health plans. The IRS defines a high-deductible health plan as one with maximum annual deductible and other out-of-pocket expenses of $6,550 for an individual and $13,100 for a family.
And withdrawals from HSA plans must be used for qualified medical expenses, such as medicines, doctors' visits and hospital costs. HSA rules for qualified medical expenses are, however, looser than you might think. They may allow such things as yoga classes for wellness, Delaney says.
You can pay for qualified medical expenses with a debit card connected to our HSA account. Or you can pay for them by other means, such as a personal checking account or credit card, and then reimburse yourself from your HSA.
There are also limits on the amount of money you can put into an HSA each year. For 2016, IRS rules allow an individual to contribute $3,350. A family can contribute up to $6,750. However, there is no maximum balance for an HSA and some savers accumulate six-figure sums.
Because of their triple tax-free feature, HSAs are attractive places to put money after you've taken full advantage of employer-matching in company retirement savings plans, Keckler says. One of the advantages of an HSA compared to an IRA or 401(k), Keckler notes, is that you can access the money before retirement without paying a penalty as long as it is for a qualified medical expense.
You do, however, have to pay a 20% penalty on withdrawals before age 65 for non-qualifying medical purposes, such as elective cosmetic surgery. You can pay non-medical expenses after age 65 without penalty, although you will pay taxes.
Another benefit of an HSA compared to employer-sponsored retirement plans is that it follows you when you change jobs. Some savers take advantage of an IRS rule that allows them to fund an HSA with a transfer from a traditional IRA or Roth IRA. You can't fund an HSA from a SEP IRA or SIMPLE IRA, however.
HSAs are such effective and efficient savings vehicles that Delaney recommends savers who can afford to pay for their current expenses out of pocket rather than tapping their HSAs. "Think of it as a savings plan instead of a spending plan," she suggests.
And they're not just for retirement. Delaney recommends savers in their 20s consider funding HSAs. The reason: they can anticipate higher healthcare costs later in life as they marry and start families.
Since they were introduced in 2003, HSA plans have evolved from offering money markets as investment options to including mutual funds. However, Delaney says many HSA mutual funds have excessively high fees. She says employers are beginning to look for HSA plans with lower-cost funds. As new fiduciary rules come into effect governing advising employee retirement plans, she expects that trend to accelerate.