Health Savings Accounts as Supplemental Retirement Vehicles

Stethoscope with Dollar SignI was recently quoted in an article aimed at helping Gen Xers gear up for retirement (see this post).  Some of you who read the article have asked for a bit more meat on my comments about using the Health Savings Account (HSA) as a supplemental retirement account.  Wish granted!

Let’s start with the most important word in the paragraph above: ‘supplemental.’  The HSA was not created as a retirement account, and so it’s not the most effective option in that space.  That being said, if you’re maxing out your 401(k) and Roth IRA options, some of the idiosyncrasies of the HSA can be pretty handy.

The HSA was designed as an account where participants in high deductible health plans (HDHP) could set aside money to offset medical costs as they arise.  As part of the incentive to do so, contributions to the HSA receive three types of preferential treatment:

  1. Contributions are tax deductible (they can lower your taxes for this year).
  2. Any money in the HSA grows tax-deferred.
  3. Withdrawals from the HSA to pay for qualified medical expenses are tax free.  Withdrawals for reasons other than qualified medical expenses result in a penalty of 20% of the withdrawal amount and taxes on the growth.

“But, Tony!” you say, “Why on Earth would I want to expose myself to a 20% tax penalty on my withdrawal and taxation?  That completely erodes the benefit of pre-tax contributions and tax-free growth, doesn’t it?”

Enter the final wrinkle: after the account holder reaches age 65, she is no longer subject to the 20% penalty.  So, let’s run this through our “best case/worst case scenario” test.*

Best case:

In the best case, you make contributions to your HSA and get a tax benefit this year.  You make it to retirement with an extra pot of tax-benefited money to go alongside your traditional IRA/401(k)/403(b) and your Roth holdings.  You have the option to use it for any medical expenses that come up, in which it’s tax-free income (like the Roth funds, but with the added benefit that you got a tax benefit when you put it in, too).  If you don’t have medical expenses, or you’ve exhausted other traditional IRA money, you can still tap the HSA funds.  Sure you’ll pay ordinary income taxes, but you would have paid that on IRA funds, anyway.  Flexibility is one of the most under-appreciated benefits of a solid financial plan.

Worst Case

You get the tax benefit of putting the money into the HSA, but then you run into hard times.  So hard, in fact, that you’ve exhausted your non-qualified savings, tapped your IRA funds, and now have to start spending your HSA money, too.  You’ll have to pay the income tax that you didn’t pay up front, as well as a 20% penalty on the withdrawals, assuming you have NO medical expenses to offset.

The worst case seems pretty grim, I’ll grant that, but let’s dissect it a bit.  First, did you notice the order in which you’d spend down the assets?  You’d have to spend everything you have in your non-qualified accounts, since it’s yours without any strings attached.  Then, if you couldn’t (or elected not to) take a 401(k) loan, you’d have to spend through all of your Roth IRA funds (10% penalty, but no taxes, because you paid them already), then your traditional 401(k)/IRA funds (10% penalty AND ordinary income taxes due).  Finally, you’d tap into your HSA.  I can really only think of one type of catastrophic event that would cause someone to unload all of their assets like this: unexpected health problems resulting in astronomical medical bills.  Can you see how unrealistic the worst case scenario really is?

So what’s the bottom line here; what can you take away?**

First, make the decision on the type of health plan you have.  If it’s an HDHP, then you’ll have the option to utilize the HSA.  Also determine the amount you should be setting aside into the HSA for its true purpose: offsetting medical expenses in your high deductible plan.  Then, do your research or work with your financial adviser to determine if you should be maxing out your retirement plans.  If you are making the maximum contributions to the plans available to you, put additional funds into the HSA.  Where it makes sense over the years, pay your medical expenses out of cash flow.  Many people who could pay their deductibles out-of-pocket pull money out of the HSA to offset those expenses before they realize that they’re “robbing Peter to pay Paul” by using dollars that could have benefited from continued preferential tax treatment, instead of the funds outside the HSA.

Finally, a note for those of you already in retirement who are trying to decide whether or not to use HSA funds.  You can get into some pretty complicated discussions about which account you should be drawing from in any given year.  There’s one answer from an estate planning perspective, and a whole slew of them from a tax planning perspective.  When you’re making a decision to use HSA funds or not, take the following into consideration:

  • Did you have medical bills that you can offset this year?  If so, the HSA withdrawal is tax-free to that extent, like your Roth funds.
  • Do you expect to have medical expenses in the coming years?  Knowing about a condition that will involve constant medical expenses can help you consider your HSA funds a a tax-free multi-year income stream.
  • Are you actively trying to push assets out of your estate, or create other benefits for your heirs?  The HSA stops being an HSA and the fair market value of the the account becomes taxable income to the beneficiary in the year you die.  Note the difference from other IRAs and non-qualified funds.

I hope you found this content useful, and if you have any questions, please feel free to ask via the comments section, or drop me an email!


IRS Publication 969 – For you gluttons for punishment, here’s the link to the IRS publication regarding “Health Savings Accounts and Other Tax-Favored Health Plans.”

HSA Bank – This is one option for opening an HSA.  It’s not an endorsement, just a place to get you started.

*Remember, the best case/worst case scenario always has today’s taxes and legislation in mind.  We can’t predict the future of the tax code or law, but we have to make educated assumptions starting somewhere.

**Everyone’s situation is different.  Your financial life may contain items that make this general recommendation unsuitable.  Before acting, do your research or consult with your financial adviser.  Seriously.

Health Savings Accounts as Supplemental Retirement Vehicles

4 thoughts on “Health Savings Accounts as Supplemental Retirement Vehicles

  1. One thing I intentionally stayed away from above was the specifics about contribution limits, as they change annually. That being said, it’s worth mentioning that there is no INCOME limitation on who can contribute to an HSA.


  2. Matt says:

    Any thoughts on whether this idea is good/legal? Is it worth hoarding unpaid medical expense receipts?

    “HSA dollars do not have to be withdrawn in the same year as the healthcare expense. Although this rule may change at the whims of Congress, as the law currently stands you do not have to withdraw money from your HSA in the same year you purchase healthcare. Thus if you have a baby at age 35, if you keep your receipts, you can take that HSA money out at 55 and use it to buy a boat, tax and penalty-free.”


    1. This works because of the way ‘Qualified Medical Expenses’ are defined. The timing portion dictates that QMEs are those that would otherwise qualify and were incurred after the HSA was opened.

      In other words, since you don’t have to take the HSA distribution in the same year you in cure the medical expense, you can pay expenses out of cash flow and come back for the distribution later. You can use the money on anything (boat included) because you’ve technically already used it to pay the medical QME.


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