If you’re searching for a tax-smart way to invest money for retirement, don’t overlook an option that might be right in front of you during open-enrollment season: Your health insurance plan.
That’s because one of the most common types of health policies now offered by employers is paired with a special investment account — one that lets you set aside money for future medical expenses without ever having to pay taxes on contributions, returns or withdrawals.
And while you have to spend money on qualified medical expenses to cut out the IRS completely, you can withdraw money for any purpose once you turn 65 and enjoy tax benefits like those you get from a 401(k). “It’s still a good deal,” says Jonathan Kahler, an investment analyst at Vanguard
The investment account at issue is what’s known as a health savings account (HSA), to which you can contribute if you are enrolled in a high-deductible health plan (HDHP). In 2018, that means a health plan with a minimum deductible of $1,350 for employee-only coverage and maximum out-of-pocket expenses, excluding premiums, of $6,650. (Double those numbers for family coverage.)
More than 28 percent of employees with health insurance were enrolled in an HDHP plans in 2017, according to the Kaiser Family Foundation. Among employees offered health insurance, 57 percent had an HDHP as either one of several options or their only choice for coverage.
To lessen the sting of an HDHP’s high deductible, employees can set aside a certain portion of their pretax earnings in an HSA, similar to how workers can put part of their salary into a 401(k) or 403(b) without having to pay taxes on the contribution. Between you and your employer (about half of firms offering HDHPs make contributions to HSAs), the maximum amount you can add to the HSA in 2018 is $3,450 for an employee-only plan and double that for a family plan. For each covered person who is 55 or older, you can add another $1,000 in catch-up contributions.
The HSA is similar to the more-common health care flexible spending account (FSA), which allows workers — whether or not they have health coverage — to set aside earnings tax-free to cover a wide range of qualified medical expenses, such as prescription drugs and doctor visits.
But unlike the case with FSAs, which have a use-it-or-lose-it provision (you forfeit money you’ve contributed to the account if you don’t spend it on expenses incurred by a certain deadline, usually year-end or soon after), the money in your HSA can stay there for years.
Another important difference: Unlike the case with FSAs, you don’t have to keep the money in cash. You can invest some or all of it in securities such as mutual funds, just as you can with a 401(k), giving you the opportunity for higher investment returns.
As with a 401(k), that growth comes tax-free. Even better, if you spend the money on medical expenses, you can withdraw money from an HSA tax-free.
In contrast, while money you contribute to a 401(k) or a traditional IRA can reduce your taxable income and grow tax-free, money that you pull out of those accounts, whether for medical expenses or anything else, is subject to taxation at ordinary-income rates. And unlike the case with Roth IRAs and Roth 401(k), which also enable tax-free growth and withdrawals, you can fund an HSA with pretax income.
If you don’t use the money from an HSA for qualified health expenses, the tax treatment of withdrawals starting at age 65 is comparable to that of a traditional IRA, asserts Vanguard in a recent paper. (Pull money out for nonmedical expenses before then, and you’ll pay a 20 percent penalty on top of ordinary income taxes.)
But chances are you’ll have plenty of opportunity to use tax-free withdrawals. For example, HSAs can also be used to pay for Medicare premiums (but not Medigap premiums) or buy long-term care insurance.
“For most people,” says Kahler, “they’ll have enough medical expenses to really justify putting as much money into that HSA as possible.”
These tax advantages of HSAs make them a good retirement savings option alongside 401(k) and IRAs, says Vanguard. So if you have sufficient financial resources, the firm recommends funding medical expenses with taxable income and investing money in the HSA for later.
But even if you don’t have enough spare cash to save for retirement, according to Vanguard, it still pays to contribute to an HSA and use that money for current medical expenses, since you won’t be taxed on the money you put in.