Thankfully, there's a savings vehicle with powerful features that can make it easier to save for future health-related expenses: Health Savings Accounts (HSAs). These accounts are available to individuals or families covered by qualified high deductible health plans (HDHPs), and typically provide investment options similar to a 401(k).
These accounts are one of the most tax-friendly investment vehicles available to investors because they are triple tax-advantaged: no tax on contributions, growth, or distributions (as long as these funds are spent on qualified medical costs). Removing this tax drag can mean thousands of dollars of tax savings on healthcare costs.
Near-term spending or tax-free growth?
Most Americans are spending more than they are saving in their HSAs. Only 24% of assets contributed to HSAs in 2019 were carried forward into 2020. While individuals do have the option of using HSA dollars during their working years, similar to Flexible Spending Accounts (FSAs), HSA savings are not subject to a "use it or lose it" time horizon. FSA dollars must be earmarked for near-term spending, whereas unspent dollars in an HSA can be carried forward for many years. That's an important feature because the benefits of tax-free growth compound over time.
In addition to leaving your savings in your HSA until the funds are needed in retirement, we also recommend utilizing the investment feature in order to reap the full benefits of your HSA. As of 30 June 2020, only 5% of accounts invested a portion of their HSA dollars. That means 95% of HSAs were held entirely in cash or the account's money market fund. That could be a huge missed opportunity, because the cumulative effect of HSA's triple tax advantage is remarkable.
HSAs offer a triple tax advantage
- Pre-tax contributions, similar to a Traditional IRA or 401(k) contribution
- Tax-free investment earnings
- Tax-free distributions when they are used to cover qualified medical expenses
HSAs can be used to cover future healthcare costs in retirement. Their triple tax benefit makes it easier to save for healthcare costs in comparison to other retirement savings accounts. But, they should not be the primary source of funding for healthcare spending in retirement. Instead, HSAs should be used as a part of your overall retirement savings strategy.
If you're currently maxing out your 401(k) contributions, do the same to your HSA. If you aren't able to max out your 401(k) or HSA, contribute at least enough to your 401(k) to receive your entire employer match (if applicable) and then direct additional savings toward your HSA.
And, when feasible, fund pre-retirement healthcare expenses with after-tax dollars. This will allow the assets in your HSA to benefit from long-term tax-free growth and tax-free distributions on qualified expenses.
For details regarding what medical expenses are qualified for HSA distributions, along with other HSA-related information, please see IRS Publication 969.
Main contributor: Ainsley Carbone, Total Wealth Strategist Americas
Read the full report HSAs and the power of tax-free growth 8 Oct. 2020.
Product of the UBS Chief Investment Office.