How to Use a Tax-Saving Health Savings Account in Retirement

A Health Savings Account (HSA) lets you save money in a tax-advantaged account and then withdraw cash tax-free to pay for qualified medical expenses. Often, the money is used while you're working. But you can also use your HSA in retirement to help lower your out-of-pocket medical costs then. Doing so could help stretch your retirement savings, too.

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"While no one can predict what their health care costs will be in the future, we estimate that health care costs will rise four percent annually, so the numbers can get daunting pretty fast," says Kevin Webber, a wealth adviser at Heritage Financial in Westwood, Mass. "HSAs can give clients some control over their tax bill when deciding how to pay those health-related costs."

Before explaining how best to use an HSA in retirement, a brief definition:

In 2021, you can put up to $3,600 in pre-tax money ($4,600 if you're 55+ and $7,200 for a family or $8,200 for a family if you're 55+) in an HSA. Earnings from its investments aren't taxed; neither are withdrawals for qualified medical expenses. But to qualify for one, you must have a high-deductible health insurance plan — one with a minimum deductible of $1,400 for an individual or $2,800 for a family. (Roughly 35% of employers offer high-deductible plans, according to Bank of America.)

Before age 65, if you use HSA money for a non-qualified medical expense, you'll owe a 20% tax penalty on the amount of your withdrawal and the money you take out for that expense will be taxed as ordinary income.

You can't continue contributing to an HSA once you're on Medicare; if you do, you'll owe tax penalties.

After you die, your spouse or partner can inherit your account and turn it into their own HSA. But any money your children inherit from your HSA will be fully taxable.

Some 30 million Americans are using HSAs, says Jon Robb, senior vice president at Devenir, an HSA investment firm based in Minneapolis. Yes only 45% of people who may qualify to open an HSA have actually opened one, according to the University of Michigan's Institute for Healthcare Policy & Innovation.

On average, HSA holders older than 50 had an average HSA balance of over $4,300 in 2020. According to Fidelity Investments, the average HSA owner holds over $8,900 in it at age 65 and $8,400 in one at 70.

Although that's a drop in the bucket compared to the estimated $300,000 the average 65-year-old couple will need for health care, it's a nice start.

Here are 5 ways you can use an HSA during retirement:

Say you're 63 ½ and lose your job or decide to stop working before turning 65. You might not have access to retiree health coverage then, but could be able to stay on your hold employer's plan under the federal COBRA law for up to 18 months.

If so, you could use your HSA to pay for those premiums and even health insurance premiums while receiving unemployment compensation.

"Utilizing an HSA in the pre-Medicare scenario can help save on taxes," says Webber. "I have a number of clients using their HSAs to pay current health care expenses. This affords them the opportunity to delay tapping into their IRAs or 401(k)s to pay for medical premiums or expenses. Then, when they are in a lower tax bracket, they can convert some of their retirement savings into a Roth IRA to help reduce taxes on future withdrawals."

Here's an example Webber offers: "One of our clients, a software engineer, and his wife, a teacher, retired in their mid-sixties and used their HSA to pay for his Medicare Part B premiums. Using the HSA was the right move because her teacher's retirement pension was generous enough to place them in the twenty-two percent marginal tax bracket. Spending down the HSA allowed them to avoid taking IRA distributions to pay for Medicare, which would have been heavily taxed."

Unless you're still covered by an expensive corporate health care plan, you may be paying for vision, hearing aids and dental work from your personal savings; Medicare doesn't cover those, but you can use your HSA money for them.

Other common covered expenses for HSAs include acupuncture, blood pressure monitors, chiropractic bills, ambulance fees, diabetes supplies, non-cosmetic elective surgery and some types of medical equipment.

HSAs can also cover a portion of long-term care costs but can only pay a limited amount toward a long-term care insurance policy's premiums. For example, if you are 61 to 70, up to $4,520 can be used; up to $5,640 if you're older. Any premium amounts above those numbers are not considered to be medical expenses.

Former employee benefits consultant Nancy Helt, of Hingham, Mass., uses her HSA to help pay for future long-term care expenses, but not for long-term care insurance.

"Working with my financial adviser, we opted not to purchase long-term care insurance because the cost versus benefit available at the time did not seem to make sense," says Helt. "I'm invested in several low-cost index funds within my HSA, which will hopefully continue to grow over the next fifteen to twenty years. At that point, I may have to use those funds and other retirement income sources to pay for long-term care, live-in help or home health aides for my husband or even for me."

You can use your HSA to pay certain Medicare expenses, too, including premiums for Medicare Part A, Part B, Part C (Medicare Advantage) and Part D prescription drug coverage. But you can't tap an HSA for supplemental or Medigap policy premiums.

Here's one of the tantalizing secrets of an HSA: Once you enroll in Medicare, you can also use an HSA account to pay for any nonqualified medical expenses, like home renovations You don't have to pay state or federal taxes for such expenditures, but you do have to pay taxes on your investment gains for them.

If you're under 65, need health care coverage and want to open and contribute to an HSA in 2022, you may be able to enroll in HSA-eligible plan on the government's Healthcare.gov site. Search for "HSA" as you compare plans on the health exchange for your state. The enrollment period runs November 1 through January 15, 2022.

You can get an HSA through a bank or other financial services company or through a debit card. Just bear in mind that the terms and fees will vary by company. Some firms charge for opening or closing the account as well as monthly maintenance fees.

If you do open or have an HSA, it's worth using the investing feature to build up tax-sheltered gains. Yet a new Employee Benefit Research Institute report found that very few HSA owners invested their account balances. "On average, accountholders appear to be using HSAs as specialized checking accounts rather than retirement accounts," the report said.

David Conti is a New-Hampshire based writer, editor and content marketing specialist. He was an editor at Fidelity Investments and now writes about personal finance, retirement, aging and wealth for several national publications. Contact him on LinkedIn. Read More