When it comes to confusing lexicons, the finance industry must be one of the worst offenders. As one example, just consider the types of investment accounts available to savers: there are IRAs, Roth IRAs, 401(k)s, 403(b)s, 457s, 529s, TOD INDs, SEPs, SIMPLEs, UTMAs… and there are many more. Fortunately, nearly all of these accounts can be sorted into three main categories based on their tax treatment under the law:
- Pre-tax accounts, in which contributions are generally deductible from income; earnings and income grow tax-free; and withdrawals are fully taxable at ordinary income tax rates. These include 401(k)s, 403(b)s, 457s, IRAs, SEP, and SIMPLE retirement accounts.
- Post-tax accounts, such as Roth IRAs and 529 plans, in which contributions are not deductible, but earnings and withdrawals are tax-free after minimum age or other requirements are met.
- Taxable accounts, which are individual or joint general-purpose investment accounts, without limits on contributions or withdrawals, but accounts in which taxes are owed each year on interest, dividends income, and realized capital gains.
However, a fourth kind of account was introduced in 2003 and is designed specifically for health care costs. These accounts, known as Health Savings Accounts (HSAs), are associated with High-Deductible Health Care plans and thus are not available to everyone. But for those who can contribute, HSAs offer an attractive mix of tax and planning advantages. In fact, HSAs are triple tax-advantaged, because contributions to HSAs are deductible from income, the earnings grow tax-free, and withdrawals are also tax-free if used for approved medical expenses.
Unlike Flex Spending accounts, HSA balances do not need to be used up at the end of each year. They also are portable, so they are yours to keep, even if you change employers or retire. Spouses can inherit the used balance of their partner’s HSA, and very importantly, the cash inside of HSAs can be invested for the long-term. Given these many benefits, the HSA is an ideal long-term investment vehicle to accumulate resources over time to cover future health care costs. Despite this potential, many HSA account owners treat them more like a “health care checking account” — money flows in, money flows out, and very little is left at the end of each year. This is unfortunate because it means people are not taking full advantage of what these accounts can offer.
Nearly everyone will face significant health care costs in retirement. The average expected cost of health care during retirement is more than $300,000 per person, which includes Medicare premiums, out-of-pocket costs, and supplemental health insurance. Having access to a sizeable HSA to cover these anticipated costs, tax-free, without withdrawing from other retirement accounts, creates a tremendous opportunity for some retirees.
How large could an HSA account become by the time retirement begins? The maximum family contribution limit for HSA accounts in 2023 is $7,750. This amount is indexed to inflation, so the limit tends to grow each year. And, if you are age 55 or older, there is an additional “catch-up” contribution allowance of $1,000. Invested over 25 years, $7,750 per year grows to nearly $500,000 at a 7% annual rate of return, more than enough to cover all expected health care costs for the average retiree.
The key takeaway, for those who can afford to pay day-to-day medical costs out of pocket, is to stop using your HSA like a short-term checking account. Instead, think about taking full advantage of the power of compounding returns by investing your HSA balances in a long-term, low cost, well-diversified portfolio of global stocks and bonds. By making this one change, you may be able to significantly enhance your standard of living in retirement.