A health savings account (HSA) is a great vehicle to fund now to pay for health care costs in retirement.

Lifetime use
Once you have reached the point in your financial life where you can maximize savings for retirement, consider maximizing contributions to your HSA. Then pay for current healthcare expenses out-of-pocket while you have the higher income or extra resources. This leaves your HSA intact to grow and compound tax-deferred, to serve as a pot of money to use for healthcare costs in retirement. Your HSA provider may even have an option to invest the money for better long-term returns than sitting in cash.

You would essentially be contributing more pre-tax dollars to retirement savings beyond the 401(k) limits, just to a different account—and, even better, it has more tax benefits. Not only are contributions pre-tax and earnings tax-deferred, but qualified withdrawals (for health care) can come out tax-free. That is especially valuable in retirement, when you need to preserve every dollar. This could make it better to prioritize maximizing contributions to the HSA first, then to your 401(k) or 403(b) plan for retirement savings. Keep in mind that any contributions made within six months of applying for Social Security or Medicare Part A are not allowed. They would need to be withdrawn, plus earnings, by the due date of that year’s income tax return to avoid excess contribution penalties.

Note that anyone can contribute to your HSA as long as the total contributions to the account are within the annual limits. And … you still get the tax deduction (they don’t). It counts as a gift from them but it’s eligible for their gift tax annual exclusion ($15,000 for 2018). Likewise, you can contribute to someone else’s HSA (i.e. a working child or significant other).

If you need to use the account for other purposes, you can withdraw funds penalty-free after age 65. The distributions would be taxable, since they would not be for qualified medical expenses, but that is no different from 401(k) withdrawals.

Most people underestimate the money needed for retirement, especially when you factor in inflation—the silent thief—over all that time. Early on, it might seem that the numbers are working out. However, in a matter of time, inflation could cause the numbers to flip the other way. Healthcare costs in retirement are part of the mix that the rest of your savings would otherwise have to cover.

At your death
What if there is a balance in your HSA from all that good accumulating and investing? The balance would transfer to your named beneficiary, just like a beneficiary designation on your retirement account. Therefore, it is important to make sure you have named a beneficiary. The beneficiary does not have to be eligible to contribute to an HSA (have HSA-eligible health insurance) in order to inherit the account.

  • Your spouse as beneficiary—Your HSA would become your spouse’s own HSA. Your spouse gets the same tax benefit of tax-free withdrawals for qualified medical expenses. If your spouse has HSA-eligible health insurance, (s)he can also contribute to this HSA.
  • Your children or other non-spouse as beneficiary—Other beneficiaries do not have the same tax benefits as a spouse beneficiary. The value of the account, less any qualified medical expenses paid by the beneficiary within one year after the date of death, is taxable in the year of your death. That could be a big tax hit, but there is no other choice if you are not married or have other reasons for not naming your spouse.
  • Your estate as beneficiary—In this case, the HSA balance would be taxable on your final tax return. That may make sense if you are in a lower tax bracket than your child.

Every dollar has so many places to go, and prioritizing can be a balancing act. Certainly, paying down high-interest debt and having an emergency fund are priorities. An HSA can be a valuable vehicle for accumulating funds for retirement healthcare costs once you are in a position to do so.

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