When saving for retirement, you’re probably aware of the benefits of using tax-preferred accounts such as 401(k)s and IRAs. But you may not be aware of another type of tax-preferred account that may prove very useful, not only during your working years but also in retirement: the health savings account (HSA).
An HSA is a tax-advantaged account that’s paired with a high-deductible health plan (HDHP). You can’t establish or contribute to an HSA unless you are enrolled in an HDHP. An HDHP provides “catastrophic” health coverage that pays benefits only after you’ve satisfied a high annual deductible. However, you can use funds from your HSA to pay for health expenses not covered by the HDHP. Contributions to an HSA are generally either tax deductible if you contribute them directly, or excluded from income if made by your employer. HSAs typically offer several savings and investment options. Your employer will likely indicate which funds or investment options are available if you get your HSA through work. All investments are subject to market fluctuation, risk, and loss of principal.
When sold, investments may be worth more or less than their original cost. Withdrawals from the HSA for qualified medical expenses are free of federal income tax. However, money you take out of your HSA for nonqualified expenses is subject to ordinary income taxes plus a 20% penalty, unless an exception applies.
An HSA can be a powerful savings tool. First, it may be the only type of account that allows for federal income tax-deductible or pre-tax contributions coupled with tax-free withdrawals. Depending upon the state, HSA contributions and earnings could be subject to state taxes. In addition, because there’s no “use it or lose it” provision, funds roll over from year to year. And the account is yours, so you can keep it even if you change employers or lose your job.
During your working years, if your health expenses are relatively low, you may be able to build up a significant balance in your HSA over time. You can even let your money grow until retirement, when your health expenses are likely to be greater. In retirement, medical costs may prove to be one of your biggest expenses. Although you can’t contribute to an HSA once you enroll in Medicare (it’s not considered an HDHP), an HSA can help you pay for qualified medical expenses, allowing you to preserve your retirement accounts for other expenses (e.g., housing, food, entertainment, etc.). And an HSA may provide other benefits as well.