According to recent estimates by Fidelity Investments, a couple will incur an estimated $280,000 worth of medical expenses after turning 65 years of age. They estimate this cost every year and when they publish it, I can’t help but have an anxiety spike as I ponder the reality of that number. Even if they are off and have over-estimated by 50%, the remaining number is still very hard for me to swallow. And, as anxiety has habit of doing, it sends me into panic mode and I scramble to reevaluate my retirement planning in an attempt to ward off the eventual doom and gloom that has settled on the far horizon of my life.
After a few deep breaths, I settle down and remind myself that I have a health savings account (HSA) that I have faithfully been contributing to over the past several years and that I plan to continue contributing to as long as I am eligible to do so. HSAs are a great way to plan for medical expenses, either in the future when you retire, or now when you or a member of your family incurs qualified medical expenses. Here’s the run down on how they work.
HSAs are a savings account option that allows individuals that are covered by a high deductible health plan (and that are not covered by any type of insurance other than a high deductible health plan), to set aside a certain amount of their income on a pre-tax basis to pay for medical expenses that arise. Unlike health flexible spending accounts that are similar in that individuals can set aside pre-tax dollars to pay for qualified medical expenses, funds put into an HSA are not forfeited at the end of the year if you don’t spend them. Said differently, HSAs don’t have the “use it or lose it” component. If you don’t use it, you keep it, and if you do that year after year, the balance in your HSA can grow exponentially!
An HSA works essentially like this. Each year the government sets a maximum amount that qualified individuals are able to put into an HSA on a pre-tax basis. For 2018, this amount is set at $3,450 for individuals that have single coverage under a high deductible health plan (HDHP) or $6,900 for individuals with family coverage under an HDHP plan. Then, these funds can be used to pay for qualified medical expenses that are incurred. This would be for out-of-pocket expenses that aren’t covered by their health plan such as copays, deductibles or qualified expenses not covered by the plan.
The concept for HDHPs is that they are a type of consumer-driven health plan that results in individual consumers having more “skin in the game,” leading them to be more conscientious consumers of health care, thereby helping to control the rising costs of health care. To assist individuals to pay for the higher costs they are responsible for prior to meeting the higher deductible, the government was willing to also have more skin in the game by forfeiting tax dollars and allowing HSA contributions to be made on a pre-tax basis to pay for these costs. Employers who allow employees to contribute to HSAs on a pre-tax basis also benefit by reducing the amount of FICA taxes that they are required to pay.
The goal of the HSA was not only to help pay for these higher, pre-deductible expenses, but also to provide a mechanism for individuals to save for medical expenses once they reach retirement. After all, discussions and debates continue regarding whether or not Medicare will continue to exist in the years to come.
If you contribute to an HSA and then use those funds for qualified medical expenses, you pay no taxes on those funds. In essence, you are lowering your expense by the amount of taxes you save. If, however, you dip into your HSA to pay for non-qualified expenses, then you are subject to taxes on those funds plus a 10% tax penalty.
Some individuals balk at contributing to an HSA because they feel they will not incur qualified medical expenses in the coming year. Other individuals limit their HSA contributions to the amount of qualified medical expenses they expect to incur in the coming year. Still others try to contribute the maximum amount each year regardless of what they anticipate their costs being. Why?
In addition to contributing dollars on a pre-tax basis, many banks that offer HSAs also offer investment options for those accounts, so that you can increase your funds through investments on top of the on-going contributions that you deposit. And, this investment growth is also available to you on a tax-free basis as long as the funds are used for qualified medical expenses! I find this refreshingly reassuring as I peek into my account and see that it is growing, and it not just because I’m dumping money into it. So max-funding an HSA and investing those dollars allow you to earn even more dollars on top of the pre-tax dollars. I look at this as free money!
Because of this growth potential, leaving funds in the account even when you do have qualified medical expenses can be an advantageous investment maneuver. What? Not use the funds when you have a qualified expense? Yep. You are not required to take funds out of your HSA at the time that a qualified expense occurs. You can leave that money in your HSA and, as long as you keep your receipts showing that you paid for those qualified expenses, you can wait to reimburse yourself for that expense at any time in the future, even if you are no longer covered by an HDHP when you decide to reimburse yourself. You see, although you are only eligible to contribute to an HSA when you are covered by an HDHP, you can take the money out for qualified expenses at any time in the future. I love this option. I put as much money into my HSA as I can, and as long as I have the funds in my personal operating account, I pay for qualified medical expenses with that money. I save all of those receipts and if in the future I’m short on money in my operating account for whatever reason, I can then reimburse myself for prior qualified medical expenses from my HSA. If I never need to do this, good for me; I leave the funds in the HSA and I continue to reap investment growth. There’s that free money again!
But what if I reach retirement and I’m still healthy? What if I manage to accumulate $140,000 in my HSA and I end up NOT having $140,000 in medical expenses? Will I encounter a “use it or lose it” option at this point? Nope. If I’m fortunate enough to be healthy with minimal medical expenses after turning 65, the funds in my HSA can operate exactly like my 401(k). Meaning, if I withdraw the funds for non-medical expenses after turning 65, those funds are subject to taxes, but they are no longer subject to the 10% tax penalty that I would have incurred if I used the funds for non-medical expenses prior to turning 65. And, just like a 401(k), the anticipated tax rate after I turn 65 is expected to be lower so I won’t pay as much in tax as I would have if I had taken those funds in my paycheck back when I was younger. Although my goal is to contribute to both my 401(k) and my HSA, I try to max-fund my HSA first and then I fund my 401(k) with as much as I can after that. Why? Because, once I reach 65 my HSA performs just like my 401(k) if I choose to spend the dollars on non-medical expenses. However, if I do have medical expenses, the funds I take from my HSA to pay for those expenses are “tax-free.” If I had to use money from my 401(k) for medical expenses, that money would be taxed!