Considering HSAs as a retirement supplement

Human Capital BulletinA health savings account (HSA) is an account used with a high-deductible health plan. An HSA provides a vehicle for paying medical expenses towards any deductibles, co-insurance, co-pays, and medical expenses that may not be covered by a health insurance plan. However, many accountholders do not realize that an HSA can also be a useful retirement supplement.

To contribute, the insured must be covered by a high-deductible health plan, cannot have other health insurance coverage, and cannot be enrolled in Medicare.

There are many benefits of an HSA:

  • Employee contributions are pre-tax, similar to traditional 401(k), 403(b) or 457(b) deferrals.
  • Employee contributions are not considered wages, so FICA, FUTA, or RRTA taxes do not apply.
  • Employer contributions are excluded from gross income.
  • HSA contributions are immediately vested.
  • HSA contributions remain in the account until used.
  • The interest and earnings on HSA assets accumulate tax-free.
  • Distributions are tax-free if used to pay qualified medical expenses.
  • HSAs are portable – an individual can keep their HSA if they change employers or leave the workforce.

HSAs have a triple tax advantage: 1) contributions are pre-tax, 2) interest and earnings accumulate tax-free, and 3) distributions are tax-free if used to pay for qualified medical expenses. In addition, there are no required minimum distributions. For 2018, the individual contribution limit is $3,450 and family limit is $6,850. For employees age 55 and over, an additional $1,000 contribution is allowed.

If funds are withdrawn before age 65 and not used for medical expenses, they are taxable as well as a 20% penalty tax is applied. After age 65, the 20% penalty no longer applies.

Another advantage is that the account does not have a “use-it-or-lose-it” requirement as with a flexible spending account. Unused funds continue to accumulate which makes this an attractive retirement supplement to pay health expenses incurred during retirement. Funds may also be used to pay Medicare premiums as well as dental and vision care, which are generally not covered by Medicare. Some people avoid maxing out their HSA contributions because it is difficult to project future medical costs. Medicare premiums, however, are a monthly, predictable expense that can be funded through HSA dollars.

Based on the tax advantages and the ability to accumulate funds in the account, an HSA should be part of employees’ retirement planning. HSAs could be completely tax-free, if distributions are used to pay for qualified medical expenses, while defined-contribution retirement plan distributions are taxed at ordinary income rates. Of course, in addition to maximizing contributions to retirement plans, maximizing contributions to an HSA should be considered as a retirement funding vehicle.

However, many employees cannot afford to maximize contributions to both a retirement plan and an HSA. Due to the tax advantages of an HSA compared to a retirement plan, maximizing contributions to an HSA before a retirement plan may be advantageous to some. One strategy would be to contribute enough to the retirement program to get the full employer match. Additional funds, if any, would be contributed to the HSA, and any contributions above that would be contributed to the retirement program.

The example below shows various scenarios of savings accumulation in an HSA or a 401(k) plan. These scenarios assume equal annual contributions for 30 years, a 5% investment return, and a 22% tax rate at retirement. Each scenario begins with $3,000 available to contribute each year.

In the HSA scenarios, all $3,000 is contributed to the HSA. In the 401(k) scenarios, FICA taxes are factored in so only $2,787 is contributed each year, with the remaining $213 reserved to pay FICA taxes. The purpose of this illustration is to show that there are many variables that factor into the decision to fund an HSA or retirement plan, and in some cases (especially when there are large matching contributions) it may be beneficial to fund a retirement plan first. Each situation is unique and individuals should consider the following when deciding whether to fund their HSA or defined contribution retirement plan:

  • Does the retirement plan have a matching component?
  • What is their expected tax rate in retirement?
  • What are their projected future medical costs?
  • How much can they afford to contribute annually?
savings accumulation in an HSA or a 401k plan
There are many scenarios where it would be beneficial for an individual to fund their HSA before their defined contribution retirement plan, and communication to employees regarding an HSA as a possible retirement supplement should be considered. Be certain employees do not focus too much on accumulating funds in their HSA and thereby defer needed medical treatment. In addition, if your plan does not have an investment arrangement for the HSA accounts, consider offering one. Be sure to look at fees involved to be certain they are reasonable.

Matt Roskopf
Senior Associate
Human Capital Services
T +1 312 602 9013

Andy Mechavich
Director - Tax
Human Capital Services
T +1 312 602 8167

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