Over the past decade, many investors have begun to realize that their employer-sponsored retirement plan assets (whether they be part of a defined contribution plan or a defined benefit plan) may not be enough to support their income needs in retirement. Many investors who are maximizing contributions under their employer-sponsored 401(k) plans and IRAs are seeking additional options for tax-deferred savings. For some, the solution may be available through the type of employer health care plan they participate in and its associated health savings account (“HSA”).

{I discuss more about health more about general healthcare costs in retirement in this short radio segment.}

Health Savings Plan (HSA) Explained

One stipulation for an employee to have an HSA is coverage under a high-deductible health plan (“HDHP”). There has been substantial growth in HDHP enrollment over the past decade as more employers offer HDHPs; the Kaiser Family Foundation 2021 health benefits survey found that 59% of firms offered health benefits, and of those firms 22% offered HSA-eligible HDHPs. An estimated 54 million individuals are currently enrolled in HDHPs, with 27 million owning HSAs.(1) The presence of an HDHP opens the door for more HSA participation.

When first introduced in 2003, HSAs were designed to help individuals covered by HDHPs pay for qualified medical expenses and save for similar future expenses on a tax-free basis. However, HSAs have the potential to be a very powerful retirement savings vehicle as well. Many retirees face increased medical expenses during retirement, so the need for additional assets to pay these growing expenses becomes even more important. Initially, HSAs were established at banks and other savings institutions for current health care and medical expenses. Generally, the HSA assets were either left as cash or invested in CDs with minimal returns. At first, they were not considered for long-term investment purposes. Over time, however, account owners sought investments that would yield greater returns. Now, practically all investments found in an IRA or retirement plan are available in an HSA. In addition to CDs, individuals can invest their HSA dollars in money market vehicles, mutual funds, or even self-directed brokerage accounts (subject to the limitations of the HSA provider).

HSAs combine several of the tax benefits associated with employer-sponsored retirement plans and traditional Roth IRAs: contributions are tax deductible (regardless of income), earnings grow tax-deferred, and qualified distributions are exempt from federal taxes and penalties. Although non-qualified distributions would be taxable, any penalty is waived upon reaching age 65.

Freedom of investment choice and portability between employers enable HSA owners to potentially accumulate a larger account balance to use for medical expenses (or non-medical expenses) in retirement. As with any invested asset, there is always the risk of loss due to market performance.

HSA Eligibility

Among other things, HSA eligibility is contingent upon coverage by an HDHP. As the cost of medical coverage continues to rise, employers are turning to HDHPs as a more cost-efficient way to provide medical coverage to their employees. Consequently, this shift in medical coverage offerings is contributing to the growth of HSAs. The adoption of HDHPs by employers is one of the strongest trends in employment-based health benefits and is driving the trends toward HSA-eligible health plans.(2)

For 2022, HDHPs have a minimum annual deductible of $1,400 and a maximum out-of-pocket expense of $7,050 for single coverage ($2,800 and $14,100, respectively, for family coverage).

Besides HDHP coverage, other HSA eligibility criteria include:

• No coverage by any other non-HDHP

• No enrollment in Medicare

• Cannot be claimed as a dependent on someone else’s tax return

HSA Contributions and Accumulations

While the contribution limits for HSAs are not as high as they are for 401(k) plans, it is still possible to accumulate large HSA balances over time. Long-term HSA accumulations could be used to offset health care costs in retirement. For 2021, consider that a study estimated that some couples who retired in 2021 could need as much as $361,000 to meet medical expenses in retirement uncovered by Medicare.(3)

The Employee Benefit Research Institute (EBRI) estimates a person contributing for 20 years to an HSA could save between $118,000 and $193,000, and those who contribute to an HSA for 40 years could save up to $360,000 or more (this assumes a 2.5% rate of return and no withdrawals).

One of the many great features of the HSA is that contributions can come from individuals, employers, or a combination of both. The maximum that can be contributed each year depends on the type of HDHP coverage (i.e., self-only vs. family). For 2022, the contribution limit for family coverage is $7,300 ($3,650 for self-only coverage). In addition, similar to IRAs and qualified retirement plans, HSAs also allow for catch-up contributions. For 2022, HSA-eligible individuals who attain age 55 or older before the end of the year are allowed to contribute an additional $1,000.

Contributions to HSAs in 2021 totaled $42 billion, an increase of 9% over the prior year. At the 2021 midyear point, about 18% of all accounts were unfunded.(4)

Similar to traditional IRAs, contributions made by individuals to their HSAs are tax deductible. But unlike IRAs, you can deduct your HSA contribution regardless of your income for the year. Contributions can be made by the owner of the HSA or any other person on behalf of the HSA owner. And contributions to a traditional or Roth IRA, or an employer- sponsored 401(k) plan, do not affect one’s ability to contribute to an HSA. For example, it would be possible for an HSA-eligible individual, age 56, to maximize contributions for 2022 to an IRA in the amount of $7,000, contribute the maximum deferral of $27,000 to a 401(k) plan, plus make a tax-deductible contribution of $8,300 to an HSA (assuming family HDHP coverage) for a total combined contribution of $42,300 for 2022. The individual would not be able to deduct the IRA contribution unless income limits are met.

Employer contributions to HSAs are not deductible; however, amounts contributed by the employer are generally not included in an employee’s gross income. Amounts the HSA owner or other individuals are able to contribute will be reduced by any employer contribution to the HSA for the year. Employers generally allocate contributions based on health coverage (self-only vs. family). If a variety of health insurance options are offered through an employer, one factor in considering which plan might be most beneficial is whether an employer contribution is available. Receiving an employer contribution to an HSA plus an employer match or profit-sharing contribution within a 401(k) plan is a great way for employees to maximize retirement savings potential.

HSA Distributions

There is no specific time limit on when an HSA owner must use the assets of the HSA. The ability to carry over the balance enables the account to continue to grow year after year. This, coupled with tax-deferred growth opportunities, makes it possible to accumulate large balances in an HSA for use in retirement.

The tax treatment of HSA distributions depends on the reason for withdrawal. If an HSA distribution is tied to a qualified medical expense, any contributions plus interest distributed are free from IRS penalty and exempt from federal tax. If the HSA distribution is not related to qualified medical expenses, the distribution is subject to federal tax as ordinary income and also subject to an IRS penalty of 20% (unless the owner is age 65 or disabled, or the distribution is due to death).

Remember, there is no time limit for using HSA dollars for qualified medical expenses. Therefore, if a qualified medical expense is incurred in one year but paid out of pocket, this expense can be reimbursed from an HSA at any point in the future (with receipts) without being assessed the 20% penalty.

HSA and Beneficiaries

The HSA owner can name beneficiaries to the HSA account. But the rules of inheritance are distinct from an IRA or qualified retirement plan.

A spousal beneficiary who inherits an HSA account can make it her/his own and will experience the same treatment as the original owner.

But in the case of a non-spousal beneficiary, the account must be liquidated upon inheritance. There is no penalty for the distribution due to the death of the account owner, but every distributed dollar will be treated as ordinary income to a non-spouse beneficiary. However, the taxable amount may be reduced by any qualified medical expenses incurred before death by the decedent, decedent’s spouse, dependents, and children younger than 27 that are paid within one year after death.

Therefore, account owners should factor for the tax situations of their beneficiaries when considering who to name and how to weight beneficiary distribution percentages on defined contribution plans, taxable IRAs, Roth IRAs and HSAs.

HSA Distribution Example

Lisa, who has HSA-eligible HDHP coverage, makes the maximum HSA contribution each year. From 2012 through 2022, Lisa incurs a total of $10,000 in qualified medical expenses, all of which she elected to pay out of pocket. In 2026, at the age of 58, Lisa needs $10,000. She has a large 401(k) balance; however, she is still working, and the plan does not allow for in-service distributions. She also has a large IRA balance, but any distribution she takes prior to reaching age 591⁄2 will be subject to an IRS early withdrawal penalty of 10%, because she doesn’t qualify for the medical expense or any other penalty exception. Because Lisa kept the receipts from her previously unreimbursed qualified medical expenses incurred between 2012 and 2022 and none of the medical expenses were taken as an itemized deduction at any time between 2012 and 2022, she can elect to take a qualified distribution from her HSA now without any tax obligation or the 20% HAS withdrawal penalty.

Conclusion

The unmatched tax benefits of the HSA make this savings vehicle ideal not only for accumulating assets to pay for current qualified medical expenses, but also for accumulating assets to use for other purposes (including qualified medical expenses) in retirement. Investors who are eligible for an HSA but are not maximizing contributions or are not contributing at all, may be missing out.

If you have questions about your HSA eligibility or HSA plan, please feel free to contact me anytime.

1 Bureau of Labor Statistics, National Compensation Survey, 2019.

2 EBRI Issue Brief, September 15, 2021, No. 538.

3  Paul Fronstin and Jack VanDerhei, “Savings Medicare Beneficiaries Need for Health Expenses Spike in 2021,” EBRI Issue Brief, 2022.

4  Devenir Research, “2021 Midyear,” September 1, 2021.

Source: Columbia Threadneedle