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How a health savings account can beat your retirement plan

Lesser-known health savings accounts, though not designed for retirement, provide more tax advantages than a 401(k) or other workplace retirement plans.

When it comes to saving for retirement, you probably know that 401(k)s and individual retirement accounts offer plenty of advantages. Hopefully, you’re even contributing to such retirement plans already. But a lesser-known choice for retirement savings — the health savings account (HSA) — packs in even bigger benefits that you don’t want to miss, if the option is available to you.

“A health savings account is the only one that offers a triple tax break,” said Vid Ponnapalli, a CERTIFIED FINANCIAL PLANNER® professional and founder of Unique Financial Advisors, based in Holmdel, N.J. “That is the beauty of HSAs.”

What is a health savings account?

Just as the name implies, an HSA is an account designed specifically to encourage people to save for health care costs. When you use your HSA funds to cover qualified medical expenses, the withdrawals are tax-free — and that’s just one of the tax benefits of the account. (More on that later.) And while they’re still relatively new, first offered in 2003 (the 401(k) was born in 1978), they’re rapidly gaining in popularity: At the end of 2018, the number of HSAs crossed the 25 million mark and held $53.8 billion in assets, according to financial firm Devenir, which focuses on health savings accounts.

To join the growing masses and contribute to one, you need to first have a high-deductible health care plan (HDHP), which comes with a lower monthly premium and a high deductible (again, just as the name implies).

In 2019, for a plan to be considered an HDHP, as determined by the IRS, the minimum deductible is $1,350 for individuals, and the out-of-pocket maximum — which includes deductibles, co-payments, and co-insurance — is $6,750 for individuals. For families, the minimum deductible $2,700, and the out-of-pocket maximum is $13,500. In 2020, the minimum deductible for an HSA-compatible health plan rises to $1,400 and the out-of-pocket maximum to $6,900 for individuals while the minimum deductible is $2,800 and the out-of-pocket maximum is $13,800.

For health savings accounts, the IRS-set contribution limit in 2019 is $3,500 for individuals and $7,000 for families. Plus, you can add another $1,000, if you’re 55 or older by the end of the year. In 2020, those contribution limits increase to $3,550 for individuals and $7,100 for families.

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The triple tax advantages of HSAs

Back to the piès de résistance, the big selling point for HSAs is their tax-break hat trick:

1. Contributions

You save on taxes when putting money into the account. Either your employer directly deposits the pre-tax money into the HSA before you even get to see it in your paycheck. Or you can deduct the amount you’ve contributed from your gross income yourself, lowering your taxable income and ultimately your tax bill.

2. Earnings

You can invest the money within your HSA, just like with a retirement account. And any gains, interest, or dividends your funds earn is tax-free.

3. Withdrawals

As long as the money is used for qualifying medical expenses, your distributions also come out tax- free.

What counts as a qualified medical expense? In general, anything necessary to diagnose, cure, mitigate, treat, or prevent a disease for yourself, your spouse, and any dependents. That includes deductibles, co-pays, and co-insurance, along with anything not covered by your plan, such as visits to out-of-network doctors and vision and dental care. It does not include insurance premiums or non-prescription medications. But you can use the money to pay for all Medicare premiums, except for Medigap, once you qualify for Medicare at age 65. IRS Publication 502 covers all the nitty-gritty of what qualifies.

And you want to be sure you get that right. Withdrawals made for anything that’s not a qualified medical expense gets hit with a heavy 20% penalty, on top of being taxed as regular income.

Is an HSA better than other workplace retirement plans?

Of course, a health savings account is not by definition intended for retirement savings like a 401(k) or IRA. And with such low contribution limits, it’s not going to cut it as your sole retirement savings account. But that triple tax break means you should consider filling up your HSA before maxing out your 401(k) contributions.

Plus, you can let your HSA money grow — tax-free — indefinitely. With a traditional 401(k), once you turn 70½, you have to take required minimum distributions (RMDs), which are taxed. “In that sense, an HSA offers fully tax-free opportunities, while a 401(k) offers tax-deferring opportunities,” Ponnapalli says.

But this is not an either-or situation. You can use both an HSA and a 401(k) (and an IRA, brokerage account and a plethora of other financial tools) to ensure you can afford the retirement of your dreams. Many experts recommend maxing out your HSA contributions, only after contributing enough to your 401(k) to capture any employer match. “It gets tricky with that,” Ponnapalli says. “You have to weigh the benefits of the free money versus the tax-free withdrawal of the HSA.”

So, if your employer offers to match your 401(k) contributions, up to 6% of your income, you typically first want to make sure you get that match because of the free money available. Then, you can prioritize saving in your HSA before adding more money to your 401(k). But, Ponnapalli suggests, the tax benefits of an HSA might even outweigh the lure of free money, depending on your income and other factors. A financial professional can help you crunch those numbers and decide what strategy would work best for you.

Is a health savings account right for you?

But before you even get to that point, you have to decide whether an HDHP plan, which you need in order to contribute to an HSA at all, is appropriate for you. For example, if you have health issues that require a lot of costly medical attention, including doctors visits and medications, an HDHP could wind up costing you a lot out-of-pocket and not be worthwhile.

Another issue to think about: “Lower earners may not benefit from the tax savings enough to justify prioritizing the HSA over other retirement account options,” says Taylor Schulte, a San Diego-based CFP® and host of the Stay Wealthy Retirement podcast. “It’s important to work with your tax preparer and trusted advisor to determine your best strategy.”

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Stacy Rapacon is a freelance writer whose work can be found on Kiplinger.com, U.S. News and World Report, CNBC and other online and print publications. You can find her on Twitter at @srapacon and connect with her on LinkedIn. Opinions are her own.

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