How to Use a Health Savings Account to Crush Retirement

I’m not old, but I definitely plan on getting there some day (don’t worry, I’m not going to define what age “old” is). Just like anyone else, I have dreams and visions of retiring and spending time with loved ones, playing golf every day, or doing absolutely nothing on a beach in Tenerife.

All that is well and good, but what about the times when I’m not able to do the things I enjoy because of health needs?

A recent study by the Employee Benefits Research Institute found that a couple retiring in 2022 needs about $273,000 to cover medical expenses throughout retirement, and that does not include long-term care costs. I’m certainly not naïve enough to think I won’t be sidelined at some point in my life because of a health issue. So, how do I plan for that inevitability and the associated costs?

This is where the Health Savings Account, or an HSA, comes into play. Let’s first do a brief overview of the health insurance world and how an HSA ties into it, and then what we can do to take advantage of all of it.

Already a pro? Read what pertains to you:

  1. Health Insurance Basics
  2. What is a High-Deductible Health Plan (HDHP)?
  3. What is a Health Savings Account (HSA)?
  4. HSA Examples
  5. So, How Do I Take Advantage of an HSA?

Health Insurance Basics

The basic components of a health insurance policy are referenced multiple times throughout this article so it’s helpful to first establish some definitions:

Deductible: Amount paid by us before the insurance kicks in ($500 for example)

Coinsurance: Percentage of expenses covered by our insurance (80% for example)

Maximum out-of-pocket (MOOP): This is the max amount we will pay out of our own pockets for medical expenses and our insurance will cover 100% of future expenses ($5,000 for example)

Note: All these numbers relate to a calendar year.

What Is a High-Deductible Health Plan (HDHP)?

Congress proved they can keep things simple when they came up with this name.

This is health insurance that simply has a higher deductible than other insurance plans, which means we’re on the hook for more of our medical expenses. Monthly premiums are lower to compensate for the potentially higher out-of-pocket medical expenses.

“Aren’t we just gambling and hoping we don’t need to go to the doctor since we’ll have to pay more?” I can feel you asking me this and the answer is: sort of. But there’s a huge advantage to having a HDHP: we are granted the magical powers of an HSA.

What is a Health Savings Account (HSA)?

As far as the tax code is concerned, an HSA actually does have magical powers because it’s triple tax-advantaged: contributions to it are deductible, these contributions grow tax-free, and distributions for qualified medical expenses are tax-free. There’s nothing else like it.

We’re only allowed to have an HSA if we also have a HDHP. Our health insurance provider (usually paid for by our employer) maintains the HDHP, and a custodian (think Fidelity) maintains our HSA and provides the ability to invest.

We must be under Medicare eligibility age (age 65) and cannot be covered by any other health plan to be HSA-eligible. We are also not allowed to be eligible to be claimed as a dependent by someone else (notice the requirement is eligibility, not actually being claimed).

The contribution limit is set by the IRS every year, which can be found here. For 2023, it is $3,850 for an individual and $7,750 for a family. There is also a catch-up contribution of $1,000 allowed for individuals age 55 and over for both plans.

HSA Features

We’ll talk about funding/distribution strategies in the next section, but let’s first check out some of the cool things that an HSA can do:

  1. The list of “qualified medical expenses” was greatly expanded in 2022 to include all expenses that qualify for a medical deduction (go here to check out the full list)
  2. Distributions for these qualified expenses are tax-free
    • However, if we take money out of our HSA before age 65 and it is not for qualified expenses, we will pay ordinary income tax plus a 20% penalty on the distribution
  3. There is no statute of limitations, meaning we can contribute money in 2023 and leave it invested in the account until 2063 if we wanted (completely tax-free!)
  4. At retirement, HSA funds can be used to pay for things like COBRA premiums, long-term care premiums, and prescription drugs
  5. Any money in the account we don’t use is carried forward indefinitely until a named beneficiary ultimately inherits it

HSAs are dependent on good recordkeeping. We need to have receipts that match our medical expenses, so we don’t get hit with taxes and penalties on an expense that the IRS doesn’t consider “qualified.” If we can’t prove that we paid for that bottle of Tylenol at Target with our HSA funds…smack!

Pros vs. Cons of an HSA

An HSA is about as close to a free lunch as Congress will ever allow. There are many upsides to HSAs but like all other things in the tax code, there are trade-offs. Writing out a pros vs. cons list is a helpful visual to see if an HSA could be beneficial in your situation.

HSA Examples

Let’s take all these numbers and rules and put them into practical, real-world examples of how the HDHP + HSA combo functions. We’ll be using an individual HDHP in our examples, but the family HDHP works the same way with higher limits.

There are several ways we can take advantage of HSA funds: the way Congress intended (annual reimbursement) and the way Congress didn’t foresee (delayed reimbursement). The latter strategy is a healthcare “life hack” that can pay yourself some serious dividends if utilized properly.

The Way Congress Intended

Let’s take a single, 30-year-old individual named Sam as our example. Sam’s HDHP limits and 2023 expenses are as follows:

Deductible: $1,500

Coinsurance: 80%/20%

Maximum out-of-pocket (MOOP): $8,000

Qualified expenses: $10,000

Sam is on the hook for the full deductible and 20% of all remaining expenses up to $8,000. Let’s see how that adds up:

Coinsurance$1,700 (20% x $8,500)$6,800 (80% x $8,500)

Sam would be allowed to reimburse himself for his out-of-pocket expenses, which in this example is $3,200. He cannot claim these expenses as an itemized deduction, however.

This is a great, tax-advantaged way to fund your healthcare expenses if you’re able to contribute to an HSA. Assuming a 25% tax rate, Sam would save $800 in taxes because he was able to pay the $3,200 with tax-free money. Pretty sweet for Sam!

The Way Congress Didn’t Foresee

This is where saving receipts and having good records really comes in handy.

As mentioned earlier, the IRS does not have a statute of limitations for using HSA funds, meaning there is no requirement to reimburse ourselves today for the medical expenses we incur. We can do it whenever we want! We can leave the funds invested in our HSA to compound growth and reimburse ourselves in 20, 30 or even 40 years from now.

If we can pay our medical expenses out of pocket today, our HSA ends up essentially being a 100% tax-free cash distribution in retirement that we can use for things like long-term care premiums, prescription drugs, or even that sweet vacation to Tenerife!

There are no guaranteed results with investing, but since the Great Depression nearly 95% of the 10-year rolling periods show positive returns. I like those odds if the future looks anything like the past.

The reason this works is because we saved our receipts and have records of our medical expenses, so when we take a distribution from our HSA, we can back it up with the appropriate medical expense and avoid income taxes and the 20% penalty if we’re under age 65.

Using Sam from our previous example, he would pay the $3,200 in expenses out of pocket and keep all the receipts. He’d leave his HSA funds invested in the account, which would compound growth until he reimburses himself in retirement 35 years later. Even sweeter for Sam!

So, How Do I Take Advantage of an HSA?

He doesn’t look worried about healthcare costs. Probably because he started an HSA when he was young.

Now that we have a better understanding of what an HSA is and what it can do, how do we take advantage of it?

If your employer offers a HDHP, a possibility is to negotiate for them to make the annual max HSA contribution as part of your compensation package. The insurance premiums will be lower, the contribution is deductible for them and not considered income to you, and it will help fund medical expenses for the “future you.” Everyone wins!

If your employer is unwilling to do this, look at your budget and set aside a dollar amount each paycheck to put into your HSA. Consider paying your medical expenses out of pocket if you can afford to and let your HSA funds grow over the long term.

In either case, remember that discipline is the most important trait needed to build wealth so come up with a plan, stick to it, and reap the rewards!