A health savings account or HSA is an account designated to pay for qualified healthcare expenses. It’s funded with pre-tax money, and contributions grow tax-deferred much like an IRA. As a benefit to their employees many employers also choose to make contributions as well.
Unlike a traditional pre-tax IRA however, distributions may be received free of federal income tax so long as they are used to pay for qualified healthcare expenses. While state taxation of HSA distributions do vary, the folks we serve in the state of Iowa, Colorado, and Louisiana can be assured that the same rules that apply at the federal level are followed by the state. As long as the distributions are used for qualified healthcare expenses, they are tax free.
Many folks utilize HSAs to cover medical expense each year. They may make contributions monthly, and when a big bill comes up, they make a distribution to pay for it. They’re using tax deferred income to pay for medical expenses tax free. That’s a good deal.
However, many folks may not realize how effectively these accounts can be used to plan for the inevitable medical expenses that occur throughout retirement.
There’s also a little-known funding strategy that can be used to find an HSA. It is truly a once-in-a-lifetime opportunity. Stick with me and you’ll soon be in the know!
History of HSA
First, an HSA is not an FSA, or flexible spending account. Flexible spending generally has lower contribution limits than an HSA, and the balances cannot be carried forward into the next benefit year. FSA accounts are a “use it or lose it” type of medical savings program. If you don’t use all the contributions by the end of the year, they will likely be forfeited with few exceptions.
With an HSA, all of your unused contributions, and the earnings on those contributions accumulate tax deferred. Balances can be carried forward, and they can be used in future years, even decades into the future. This potentially makes an HSA A terrific retirement planning tool for some folks.
HSAs were established as part of the Medicare, Prescription, Drug, Improvement, and Modernization Act. This legislation was signed into law December 31 of 2003 by President George W. Bush. They were developed to replace the medical savings account system in place at the time.
Later, the program was enhanced as part of the Tax Relief & Healthcare Act of 2006. Upon signing into law on December 20th, 2006, a little-known provision was added. Keep reading, and we will address this fascinating upgrade known as a Qualified Funding Distributions (QFD).
Eligibility
Who’s eligible to contribute to an HSA? Well, not everyone. To be eligible to contribute to an HSA you:
- Must have access to a High Deductible Healthcare Plan, or HDHP. If your employer does not offer an HDHP, or you have elected a healthcare plan from your employer other than their HDHP option you’re not permitted to contribute to an HSA.
- Have no other healthcare coverage.
- Can’t be claimed as a dependent on someone else’s tax return either. This may impact younger folks just staring out who are still listed as a dependent on their parent’s tax return.
- Cannot be enrolled in Medicare. Some folks continue working past age 65 either because they want to or have to. Sometimes folks will sign up for Medicare part A, particularly when they have worked enough quarters so that it is free of premiums, even if they intend on staying with their employer sponsored healthcare plan. Doing so however would eliminate eligibility to contribute to an HSA. This is one of the reasons why we insist on holding regular reviews with clients, and to consult folks we serve before they make these types of irrevocable decisions.
With a high deductible health care plan generally, your deductibles are much higher, and your premiums are lower. An HSA gives you the opportunity to take some of the money that you may be savings with lower premiums and put that towards good use.
Historic Increase to Contribution Limits
HSA contributions are permitted each year that you are eligible but limited to an annual maximum contribution. Contributions can be made for your “Self” or for your “Family.” Folks over the age of 55 are also allowed to make catch up contributions in addition to the annual maximum contribution limit.
The annual Self contribution limit for an individual in 2023 is $3,850. The limit placed on Family contributions is $7,750. For those over the age of 55 they can contribute an additional $1,000.
To give HSA users a better shot at keeping up with the rising cost of healthcare HSA contribution limits are adjusted for inflation each year. The IRS calculates annual increases to contribution limits using the Chained Consumer Price Index, and then round to the nearest $50.
Recently the IRS made an announcement regarding 2024 HSA contribution limits. Contribution limits will be $4,154 Self and $8,300 for a Family. That is an increase of $300 and $550 respectively, or an increase of 7.8% for Self and 7.1% for Family contributions over 2023.
This will be the highest contribution limit increase since the inception of HSA accounts. We can thank the rapidly increasing and persistent inflation rate for this historic moment.
Qualified funding distributions
There’s a little-known secret when it comes to funding your HSA. Did you know that you were allowed to fund it with pre-tax dollars from your traditional IRA? You can, up to the maximum contribution limit of your HSA for a given year.
It is called a qualified funding distribution, or QFD. In other words, you’re distributing from the IRA, and funding your HSA with pretax dollars. There’s no tax consequence to do so.
But why would anybody want to do this? Because the HSA distributions are tax-free. You are effectively converting for-ever taxable money to never-taxed money, a bit like a Roth conversion. However, to be tax free the HAS distributions must be used to cover qualified medical expenses.
Before you get too excited, there’s a caveat. You can only do this one time in your lifetime. You can’t do this every year. With the significant increase to contribution limits in 2024, the timing might be right for you.
Therefore, if you already have dollars saved in a pre-tax traditional IRA and you want to get them into a never-taxed account without having to do a Roth conversion you might want to consider funding your HSA next year with a QFD.
HSA and Retirement Planning
Many folks will use an HSA throughout their lifetime. Some folks will fund it with payroll deductions today and use the contributions in the same year they are made. However, that may not be the best way to go about leveraging this unique retirement planning tool.
We often encourage our clients to fund their HSA with the intention that they’re not going to use it until their post working years. We like to think of it as having another Roth IRA, only funded with pretax dollars and leveraged for qualified healthcare expenses in retirement, which frankly are inevitable.
There are many different healthcare expenses in retirement that are qualified for tax-free distributions. Prescription drugs, physical therapy, flu shots, acupuncture and the list goes on. Many over the counter medications are eligible, as are things like hand sanitizer, eyeglasses, and even dependent care like a babysitter or adult day care.
However, one of the healthcare expenses you might encounter if you retire early is health insurance premiums. If you retire prior to reaching Medicare eligibility you will need to secure health insurance. Health insurance outside of an employer provided plan can be expensive and may cause someone to think twice about retiring prior to age 65. Unfortunately, you can’t use your HSA distributions to cover health insurance premiums.
On the other hand, once you are Medicare eligible you can use them to cover Medicare premiums, as well as a whole host of other healthcare related expenses not covered by Medicare. For example, dental, vision and hearing are all qualified healthcare expenses that Medicare doesn’t cover, and you’ll have to spend money out-of-pocket. Having planned, you could use your HSA funded with pre-tax money to cover those expenses.
Conclusion
An HSA isn’t right for everybody. In fact, it’s not right for me. I’d be happy to share with you why in private conversation if you ask.
Some folks may not have access to a HDHP and therefore aren’t eligible.
However, for the right fit an HSA can be a terrific asset to help you plan for you retirement while eliminating taxes on your income today.