By Brett Gersack CFP®, AIF®, Wealth Advisor
In planning for the future, one of the most important things to consider is how to generate cash flow in retirement. Did you notice that I didn’t say income in retirement? Not all cash flow is taxed as normal income – some sources can actually be tax-free.
“If only he’d had an HSA …”
Here’s a cautionary tale. A client of mine was highly disciplined: He had maxed out his 401(k) for decades and retired with over $2 million, which he rolled over to an IRA. This account, along with his Social Security, provided him with more than enough cash flow to live a comfortable retirement. Since 401(k)s are all pre-tax money, dollars that come out of these accounts are taxed as normal income. This was not a problem for him until he was forced to have surgery and was hit with some very large medical bills. These expenses had to be pulled from his IRA. Along with his normal distribution, this “cash flow” put him in a very high tax bracket.
This could have been mostly avoided with a little planning back when he was still saving for retirement.
401(k)s and Roth IRAs are great options that contribute to retirement security. But Health Savings Accounts (HSAs), one of the most tax-efficient retirement accounts around, should not be overlooked. HSAs offer triple tax savings: You can contribute pre-tax money that will grow tax deferred. And you can withdraw the money tax-free now or in retirement to pay for qualified medical expenses.
There are number of ways HSAs can help you today and in retirement.
As I mentioned, one of the biggest benefits to an HSA is that triple tax savings. To be able to participate in an HSA, you must be enrolled in a High Deductible Health Plan at work; in 2020, this is defined as having a minimum deductible of $1,400 for individuals and $2,800 for families. As a participant, you can contribute $3,550 as an individual or $7,100 as a family per year to your HSA. Contributions are tax-deductible, so they reduce your federal income tax. Investments in the HSA account grow tax-free (at the federal level) and can be distributed without being taxed as long as these distributions are used for qualified medical expenses.
On a side note: You can also take distributions out of the account at the age of 65 for any reason, but in this case the funds will be taxed as normal income.
Unlike a flexible spending account (FSA), HSAs are not subject to the “use-it-or-lose-it” rule. You can use the HSA account to pay for current medical expenses or keep the funds in the account to grow for future medical expenses in retirement.
I explain to all my clients who are contributing to an HSA that if they’re able to pay for medical expenses out-of-pocket…. Do it! Allow the HSA to grow and use this to pay for medical expenses completely tax free in retirement. This a huge benefit to you in retirement to help control taxes when you have these expenses – whether they are small or large – in the future.
Medical expenses are going to be one of the biggest expenses in retirement. Based on past inflation, we can expect that these will only go up. If you can start saving early in a dedicated account, this will help you build a strong base for your financial security down the road.
Many HSA accounts can be invested in mutual funds, ETFs, and even individual stocks. Just like you do with your 401(k), you can invest in a range of aggressive to conservative investments to help the account grow through the years.
If you think you’re going to be using these funds in the near term, you will want to put that money into cash. With money you will not be using until retirement, you should invest more aggressively for tax-free growth. It would be a good idea to talk with your financial advisor about the proper allocation for your needs.
You can also use the HSA as an emergency account if you’re paying for your medical expenses out of pocket. To do this, you’ll need to save all of your medical receipts. If something were to happen at any point in the future – you can withdraw payment for past medical expenses and the funds distributed are tax free to you.
Recently, I was talking with a client who had saved receipts for medical expenses over the past five years. She had paid for these out of pocket, for a total of over $10,000. She needed to get funds because her roof was leaking. She was able to take a $10,000 distribution from her HSA account and use it for her home repair. Because she had receipts showing qualified medical expenses, this distribution was completely tax free to her.
This is particularly helpful if you retire before age 65 and start Medicare. You can use Cobra to bridge the health insurance gap and pay all premiums from your HSA account. Once you start Medicare, you can then pay Part B and D prescription drug coverage with your account.
When it comes to retirement planning, many people don’t realize that where they save will have a large impact on their future. If the client I mentioned at the beginning had participated in an HSA and allowed that money to grow, he would have saved thousands of dollars in taxes with a little planning and discipline. I believe that HSAs are a very valuable retirement planning tool that is massively underutilized. Because of the triple tax advantage, this is something you should look into. Talk with your advisor to see if an HSA makes sense for your situation.
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