September 25, 2019. By Matt Okaty:
If you believe that the majority of your healthcare costs in retirement will be paid for by Medicare, then you may be in for a wakeup call. According to an annual study by Fidelity, a 65-year old couple retiring this year will need approximately $280,000 to cover health care and medical expenses throughout retirement. That’s after-tax dollars, which means if the money were held in a retirement account such as a 401(k) or Traditional IRA you would need significantly more. Ouch! That’s a significant portion of most people’s nest eggs, and the estimate does not even include over-the-counter medications, most dental services or long-term care. Needless to say, the earlier in life you start saving for such inevitable expenses the better off you’ll be, especially with increasing life expectancies and healthcare inflation that continues to outpace general inflation.
One option to consider, particularly if you are relatively young and healthy, is a Health Savings Account, or HSA. HSA’s are tax advantaged accounts, similar to IRA’s, but have additional benefits. Like Traditional IRA’s, contributions are tax deductible (or made with pre-tax dollars) and whose earnings grow tax-free. However, unlike Traditional IRA’s, withdrawals from HSA’s also come out tax-free if used for qualified medical expenses. This is a triple tax break which can significantly increase the actual purchasing power of your nest egg.
If this sounds almost too good to be true, it’s because HSA’s are unfortunately not available to everyone. You can only open up and contribute to an HSA if you are enrolled in a qualifying High Deducible Health Care Plan (HDHCP), which generally have lower premiums but higher out-of-pocket costs. The idea is that the money you save from the lower premiums can be contributed to an HSA which can then be used to help pay your out-of-pocket healthcare costs. The contributions do not have to be used within a certain time frame however (unlike Flexible Spending Accounts or FSA’s which are use-it-or-lose-it at the end of each year), so if you are able to meet all of your out-of-pocket costs through other means, then your HSA can be used as an additional retirement vehicle.
The annual contribution limits for HSA’s are relatively small, at just $3,500 for an individual or $7,000 if enrolled in a family HDHCP (as of 2019), with an additional $1,000 catch-up contribution starting at age 55. Over time, though, these contributions have the potential to grow to a substantial amount due to the power of compounding. Starting at age 35, a couple who contributes the maximum amount each year and keeps the entire amount invested without making any withdrawals could hypothetically have almost $1 million after 30 years, assuming a 7% rate of return. While this might not be realistic for most people, a couple who contributed the maximum amount but withdrew 50% of the money each year to pay for healthcare costs would still have almost $500,000 after 30 years. Once you reach age 65 you can also use the money in your HSA for any purpose without penalty, although if used for non-qualified medical expenses the withdrawals would become subject to federal and state taxes similar to Traditional IRA’s.
Source: Fidelity Investments
Most HSA’s require you to keep a certain amount in cash in case you need to make a withdrawal for medical expenses. The remaining balance can be invested in mutual funds, ETF’s, or even individual stocks and bonds depending on the HSA provider. The biggest question mark, perhaps, is anticipating your health care needs, which is never completely predictable. When deciding if a High Deductible Health Care Plan is right for you, research all available plans and make sure you fully understand the out-of-pocket costs that you will be responsible for. Between deductibles, co-payments and other amounts, the out-of-pocket costs can add up to more than what you are allowed to contribute to an HSA, in which case building up an emergency fund will be equally important. If you are considering enrolling in an HDHCP and opening an HSA, it is recommended that you first speak with a financial professional to help determine what is appropriate for your situation. HSA’s are an option worth considering but are not without its risks.