The Ultimate Retirement Account
It’s that time of year again when most employers allow their employees to change their insurance plans and benefits.
This year’s open enrollment period will be particularly interesting for me because it will be my first as a married man so I will need to see if it’s worth adding my wife onto my insurance, or vice versa.
Ultimate Retirement Account
Because some of you may be researching health insurance options like I will be, I thought it’d be a great time to talk about America’s ultimate retirement account. It’s not actually described as a retirement account but if used wisely, it could be one of the best places to put funds, not only for standard retirement but also for early retirement.
So what is it?
The ultimate retirement account is better known as a Health Savings Account, or HSA.
An HSA is a tax-advantaged savings account available for people who are enrolled in a high-deductible health insurance plan.
Since people with high-deductible health plans could face more out-of-pocket costs, due to the higher deductibles, the government provides tax incentives to motivate people to save for these expenses. HSA account holders can contribute pre-tax dollars to the account and can then withdraw money from the account, tax free, when paying for qualified medical expenses.
Why is it so great?
So how does a health savings account get the incredible honor of being named the ultimate retirement account?
Before answering that, let’s first briefly touch on some of the benefits of other types of retirement accounts.
These are the most common retirement accounts and are great for two reasons:
- Your contributions to these accounts are pre-tax contributions. This means that you don’t pay any income tax on the money you contribute. So, for example, if you make $100,000 a year but contribute $15,000 to your 401(k), the IRS treats you as if you only made $85,000.
- The money in these accounts is able to grow tax free.
You eventually have to pay tax when you withdraw money but since you receive a tax break when you put money in and the money is able to grow tax free, it is usually worth maxing out these accounts to take advantage of these benefits.
A Roth IRA is different because you have to pay tax on your income up front, like you do with income that you spend, but the money grows tax free and you do not have to pay any tax when you withdraw the money after you reach the age of 59.5. So using the salary in the above example, if you contribute $5,000 to a Roth IRA, you will still initially pay tax on your full $100,000 salary but you don’t have to pay any tax when you withdraw the money.
So what about the HSA?
For most of the population, an HSA is simply a savings account for medical expenses that provides some tax benefits.
For fientists, however, I suggest you disregard the medical aspect of the account and simply think of the account as a special retirement account that you are able to contribute to when you are enrolled in a high-deductible health plan.
When used intelligently, the HSA can potentially provide the best benefits of both a Traditional IRA and a Roth IRA combined. With an HSA, you are not only able to contribute pre-tax dollars, like you can with a 401(k)/403(b)/Traditional IRA, but you can still enjoy the tax-free growth and tax-free distributions that a Roth IRA provides!
That means you could potentially have tax-free contributions in, tax-free growth, and tax-free distributions out!
How is this possible?
Well, this is all possible because of the fact that there is no rule stating that you must use your HSA to directly pay for medical expenses or that you must withdraw money from your HSA within a certain amount of time after paying for a medical expense. As long as the qualified medical expense occurred after the HSA was opened, you can withdraw money from the HSA at any time after incurring the expense to reimburse yourself.
Let’s assume that I only spend $200 a year on medical expenses. It doesn’t make sense to pay a lot of money for a fancy, full-service health insurance plan, since I rarely go to the doctor, so I instead decide to get a cheaper, high-deductible health plan with a lower monthly premium.
Since I have a high-deductible health plan, I am able to open a health savings account so I elect to put $3,000 into the account every year and I invest the account’s money in a total stock market index fund.
Because contributions to the HSA are pre-tax, depositing $3,000 into my HSA decreases my taxable earned income by $3,000.
When I go to the doctor, I can pay for my $200 yearly visit with my HSA debit card or I can pay for it with cash or with another credit or debit card instead. If I pay with my HSA debit card, that money is extracted directly from my HSA and that’s the end of the story. I just used tax-free dollars to pay for the expense and there is nothing else I can do.
If I instead pay with cash or with another card, however, I am able to withdraw that $200 from my HSA and deposit it into my normal checking account at a later time, to pay myself back for the qualified medical expense. The great benefit of having an HSA is that I can decide when to pay myself back. Since I live well below my means and have ample savings, a $200 payment isn’t going to break the bank so there is no rush to get paid back from my HSA. Instead, I am able to leave that $200 in my HSA and can sit back and watch it grow, tax-free, until I decide to withdraw it!
As long as I keep my receipts, I can withdraw the money for qualified medical expenses from my HSA at any time, in a similar way a retired person over age 59.5 can withdraw money from a Roth IRA…tax free!
So at the end of the year, I have saved myself from paying income tax on the $3,000 of income I used to fund the account, I now have $2,800 that is growing in the HSA tax free, and I have another $200 that is in the HSA growing tax free that I can withdraw whenever I want to!
Worst Case (or Best Case?) Scenario
I can hear you saying, well what if I put all this money into my HSA but I don’t have any health issues…how will I ever get my money out?
In this case, the account will simply act like a Traditional IRA with an increased distribution age (65 instead of 59.5 for a Traditional IRA). Like a Traditional IRA, your contributions to the HSA are pre-tax contributions and your contributions are allowed to grow tax free. If you don’t use your HSA funds for medical expenses, you can begin withdrawing money from your HSA account for any expenses after you turn 65, without penalty. Like a Traditional IRA, you’ll have to pay income tax on any distributions that aren’t for qualified medical expenses but you won’t incur any additional penalties or fees. Therefore, after the age of 65, an HSA is nearly identical to a Traditional IRA!
So to describe the above example in another way, the HSA at the end of the first year is like a Traditional IRA with a balance of $2,800 and a Roth IRA with a balance of $200. As I incur additional medical expenses, I can continue converting my “Traditional IRA” money to “Roth IRA” money without having to pay tax on the conversion!
Extra Tax-Advantaged Account
The HSA is particularly useful for someone like me who maxes out all of the other tax-advantaged accounts available.
Since I’m in the wealth accumulation phase of my journey to financial independence, I try to limit my taxes as much as possible so that I can make as much of my money work for me as I can. The HSA allows me to contribute more of my income to tax-advantaged accounts, which results in a lower income tax burden and a higher savings rate.
If your annual medical costs are low and you don’t expect to reach your deductible in an average year, you can reap some amazing benefits by choosing to enroll in a high-deductible health plan. Not only will your monthly costs be lower, you’ll be able to take advantage of a health savings account and all the benefits that come with it.
Let me know in the comments if you have any questions and as always, I am not a medical or tax professional so please do your own research before making any changes to your health coverage or retirement investments.
What do you think? Do you agree that an HSA is the ultimate retirement account? If not, what type of account gets your vote?
Addendum – As Nick pointed out in the comments section below, if you contribute to your HSA through a payroll deduction, you do not pay FICA taxes (i.e. Social Security and Medicare) on the contributions! I am not aware of any other retirement account contributions that are exempt from FICA taxes so this is yet another reason the HSA is the ultimate retirement account!