Sunday, August 22, 2010

Using Health Savings Accounts for Retirement Savings

One of the more interesting innovations in health insurance is the Health Savings Account (HSA).  Many employers are now offering them as part of their health insurance plans.  An HSA allows you to put away money tax-free that you can use to pay for your health care, and unused money gets rolled over from year to year.

[Note that this should not be confused with a Flexible Spending Account or FSA.  This type of account allows you to put away money tax free for medical bills.  However, this account is "use-it-or-lose-it".  If you don't use the money in your account by the end of the year, it is gone.]

The great thing about the HSA is that you don't have to pay tax when the money is going into the account, and if you use the money for health care, you don't have to pay taxes when you take the money out.  This gives you the opportunity to use this account as a vehicle to save for retirement completely tax free.

Now you might ask how you can use this money to save for retirement if you can only use it for health care expenses.  It turns out that the average person who retires at age 65 will have to spend $240,000 on out-of-pocket health expenses.  That means that a good chunk of your retirement money is going towards health care anyway.  Therefore, it might make sense to use an HSA to fund this expense.

Most people save for retirement using an IRA or 401(k) where you pay taxes when you withdraw the money, or with a Roth IRA or Roth 401(k) where you pay taxes when you deposit the money.  With an HSA you don't pay taxes on either end of the transaction.  This can save you quite a bit of dough.

Here are some examples:

Let's say you put $5,000 into a Traditional IRA or 401(k) where the tax is paid only when you withdraw your money.  At 5% annual interest, that $5,000 will grow to $13,266 in 20 years.  If you withdraw that money after 20 years and you are in the 25% tax bracket, you will get back $9,950.

Now let's say you put $5,000 into a Roth IRA or Roth 401(k).  If you are in the 25% tax bracket, only $3,750 gets deposited because you have to pay taxes on that $5,000 up front.  At 5% annual interest, that $3,750 will grow to $9,950 in 20 years.  If you withdraw that money after 20 years, you will get the entire $9,950 since you don't have to pay taxes on it.

Finally, let's consider the HSA.  Let's say you put $5,000 into your HSA.  At 5% annual interest, it will grow to $13,266 after 20 years.  If you withdraw that money to pay for medical bills, you don't have to pay any taxes.  You get the entire $13,266.  The HSA saves you $3,316 in taxes over the more traditional retirement vehicles.  Stated another way, the HSA gives you 33% more money!  What's not to like!

Traditional IRA/401(k):  $5,000 grows to $9,950 after taxes.
Roth IRA/401(k):  $5,000 grows to $9,950 after taxes.

HSA:  $5,000 grows to $13,266 tax free.

There is a caveat with using an HSA for retirement savings, though.  To be eligible for the HSA, you must have a high deductible health plan.  With this type of health plan, you pay more out of pocket for your current health expenses than you would with a traditional health plan.  That means that you will probably be withdrawing money from your HSA all during your working years to pay for your health care.  That $5,000 that you are putting in might not all stay there for 20 years.  This means that you have to wise with how you invest that money.

Most HSA's provide a range of investment options, similiar to a 401(k) plan.  Normally, if you are putting away money for 20 years, you can afford to take some risks with that money because you have a long time horizon.  However, some of the money that you put into your HSA is going to get withdrawn long before you retire.  Therefore, you have to wise about how you allocate your HSA money.  Here is one possible strategy:

Let's say that you are single without any kids.  In 2010, you are allowed to deposit up to $3,010 into an HSA.  Since you are in relatively good health, maybe you expect that your out of pocket medical expense will be about $500.  Instead of just depositing the $500 that you think you will need into your HSA, max it out and put $3,050 into it.  The first $500 will be earmarked for out of pocket expenses this year while the other $2,550 will be part of your retirement savings.

The $500 for current expenses should be invested in a risk-free investment option like a stable value fund or a money market fund or some other option that preserves your principal.

The $2,550 for retire can be invested in something more aggressive like a balanced fund or a stock fund.  The exact allocation should be based upon how long you have until retirement and your risk tolerance.

Sample HSA Allocation for a Single Individual:
  • $3,050 HSA Contribution
  • $500 for current expenses in a risk-free fund
  • $2,550 for retirement expenses in a more risky fund 
One variation is to increase the amount for current expenses by 10-20% just to have a buffer against unforeseen circumstances.  That way if you have some additional medical expenses and the stock market goes down this year, you'll still have some money available.

As you can see, the Health Savings Account can provide some opportunities to maximize your retirement savings if you choose to take advantage of it.

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