Health savings accounts could play a crucial and tax-advantaged role for clients' medical costs in retirement, but holding them until age 65 and beyond poses some complexities as well.
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The trifecta of pretax contributions, untaxed accumulation and duty-free withdrawals for qualified medical expenses in the accounts open to those with high-deductible health insurance may pay off extra in retirement — as long as financial advisors and their clients keep Medicare rules in mind and avoid a possible tax hit to non-spouse heirs in their estate plans, experts said. That's because HSA withdrawals do not affect the calculation of taxes on Social Security benefits and aren't subject to required minimum distributions like traditional individual retirement accounts.
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Advisers and their clients can count on having plenty of uses for their HSAs: the average 65-year-old who retired last year could spend $165,000 on health care during retirement, according to Karen Volo, the head of health and benefit accounts at Fidelity Investments.
"Paying medical expenses in retirement should be a part of every planning conversation, given the burden of expense in retirement. And there is no more advantageous way to prepare for those expenses than an HSA," Volo said in an email. "Once you turn 65, you can use your HSA to pay for other nonqualified medical expenses, too. You'll have to pay applicable state and federal taxes on these withdrawals, but this gives you another option for retirement income should you need it."
The 20% penalty that would normally apply to the nonmedical use of the assets goes away once the client is over 65, noted Heather Schreiber, the founder of advanced planning consulting firm HLS Retirement Consulting. However, if the client decides to enroll in Medicare when they first reach eligibility at 65, they could risk paying a 6% excise tax for excess HSA contributions if they do not cut off the payments before joining Medicare, she said.
On the other hand, they could also reap savings on the taxes for Social Security benefits by drawing from their HSAs for health expenses in retirement, due to the formula dictating those duties.
"HSAs are one of the few sources of income that don't hit the provisional income calculations, so it's a wonderful source," Shreiber said. "Everyone's concerned about the rising cost of health care and the potential for long-term care."
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She and Volo each described clients' immediate healthcare needs prior to retirement as the key challenge confronting their efforts to set aside their HSAs until retirement. Ideally, each client would contribute as much as possible "up to the yearly maximum to harness the power of compounding with your tax-free HSA dollars," Volo said.
"You can always leave a portion of your HSA balance in cash to pay for qualified medical expenses as they arise if you need to," she said. "On the other hand, it's not a bad idea to pay for medical expenses with your regular savings if you are able to; just be sure to save the receipts! Much like the account itself, 'qualified medical expenses' never expire, either. If you pay for a qualified medical expense out-of-pocket, you can submit saved receipts for reimbursement at any point. Whether it's two, 12 or 20 years in the future, you can pay yourself back with the tax-free dollars you've compounded in your HSA."
The "tricky" questions surrounding how best to use HSAs in retirement means that advisors should guide clients carefully on the timing of their Medicare enrollment and when to begin collecting their Social Security benefits, Schreiber said. The current standard expenses of more than $2,700 per year for Medicare Part B and D premiums could prove a helpful topic to raise with the clients, alongside the pronounced rate of inflation for health care costs.
"They're roughly triple what normal inflation is," she said. "Think about those expenses that you could cover using a health savings account."
