Health Savings Account (HSA) as a Retirement Plan

Posted by Lee Reams Sr. on

Health Savings Accounts (HSAs) are an oft-overlooked stratagem in retirement planning.  Individuals with high-deductible health insurance plans can establish an HSA and make tax-deductible contributions to it. Congress created these plans to help individuals pay for medical expenses not covered by insurance.  HSAs allow tax-free distributions to pay for unreimbursed medical expenses.  Distributions taken that are not used to pay for unreimbursed medical expenses are taxable and subject to a 20% non-qualified distribution penalty.  However, the 20% penalty no longer applies after reaching age 65.

Thus, by making the maximum tax-deductible contributions allowed and not using any of the funds for medical reimbursements, and through tax-deferred accumulation, HSAs can provide a significant addition to a taxpayer’s retirement portfolio.  To achieve the maximum benefit, it’s best to open a tax-deferred HSA as early as possible, since the money will grow tax-free.

For 2017, the contribution limit is $3,400 (up from $3,350 in 2016) for individual plans and $6,750 (same as in 2016) for family plans, with a catch-up contribution of $1,000 if you are 55 or older. Contributions are not allowed once enrolled in Medicare, generally at age 65 for most people.

After reaching age 65, the taxpayer can take two types of distributions:

  • Taxable – When simply withdrawing funds for retirement (tax treatment similar to a traditional IRA).
  • Non-taxable – When withdrawing funds to pay for documented expenses paid for medical care (Code Sec. 223(f)(6)) that are not covered by insurance and not taken as a medical deduction.

There is also a quirk in the law (Notice 2004-50, Q&A-39) that allows an account beneficiary to defer distributions from an HSA to later years to reimburse (tax-free) himself or herself for qualified medical expenses incurred in years prior to retirement, as long as the expenses were incurred after the HSA was established.  CAUTION: This strategy would require substantial record keeping to show that:

(1) Distributions were made exclusively to pay for or reimburse qualified medical expenses,

(2) The qualified medical expenses have not been previously paid or reimbursed from another source, and

(3) The medical expenses have not been taken as an itemized deduction in any earlier year. 

This is actually an unintended loophole in the law. There is always the chance that Congress will close it and all of the recordkeeping and planning would be for naught.