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Backdoor Strategy Boosts Tax-Free Retirement Savings 14%

Quick quiz: name the three best tax-advantaged retirement vehicles.

Okay, the first two are easy lay-ups; the 401(k) and Individual Retirement Account (IRA).

But the third?

How about a Health Savings Account? (HSA). Introduced in 2004 as a way to help individuals pay for medical expenses, they can also be a great addition to your tax-advantaged retirement savings plan if you've already maxed out on the 401(k) and IRA contributions. There's no requirement that you must use money in an HSA for health-care costs; it's perfectly legit to make it the third-leg of your tax-deferred retirement savings strategy. A family can sock away $6,150 in 2010 in an HSA ($3,050 for indviduals.) effectively boosting its annual tax-advantaged retirement savings by 14% when added to the $16,500 per person max on 401(k) contributions and $5,000 limit on IRAs.

The one catch with an HSA is that you must be enrolled in a health insurance plan with a high-deductible to be eligible for an HSA. For 2010 a family health plan must have a deductible of at least $2,400 ($1,200 for individuals) to qualify for an HSA. And yes, HSAs were preserved in the Health Care overhaul.
You get a tax break on money you contribute to an HSA. If your HSA is part of an employer-provided plan, your contributions come from a pre-tax payroll deduction. If you're investing in an HSA on your own, you can claim the contribution as a tax deduction. That tax-break is only going to become more valuable if you and your spouse have combined income of at least $250,000 ($200,000 for individuals): income tax rates for high earners are expected to rise beginning in 2011.
You have a fair amount of flexibility choosing what you want to invest your HSA in; bank savings accounts are common, though you can also invest in mutual funds; though it will be through third parties. For example, Health Savings Administrators gives HSA investors access to 22 Vanguard mutual funds; though there are extra fees involved. (Unlike a 401(k), if you use an HSA through an employer plan you are not required to stick with the savings vehicles offered through the plan. You can opt to move your money to any HSA-qualified investment. Check with your HSA administrator for details.)

While your money is invested in the HSA it is free of federal tax. And unlike the use-it-or-lose-it Flexible Savings Accounts (FSA), any unused funds in your HSA just continue to grow year over year. This is where HSAs can be great IRAs in disguise:

  • Tax Free Withdrawals for Medical Expenses at any age. Your HSA works like a Roth IRA when you use the funds for approved medical costs. Both your contributions and earnings are 100% tax free-at any age-when used for health care.
  • Tax-Deferred Withdrawals for Any Use. Wait until age 65 and your HSA becomes a shadow Traditional IRA. In addition to tax-free withdrawals used for health care, you can also use your HSA for any expense your heart desires, and you'll simply owe income tax (no penalty whatsoever) as you would with a Traditional IRA. Moreover, there's no Required Minimum Distribution with an HSA, and your assets pass to your spouse tax-free. One catch is that any money left in an HSA that goes to your non-spouse heirs becomes part of your taxable estate.

A Rare Win-Win
For families that can handle the higher deductible and high out-of-pocket annual maximums that come with an HSA, they should be viewed as a rare financial win-win. If you need to use the money for health care expenses today, you are paying with tax-free dollars. Any dollars not needed for health expenses boost your tax-deferred retirement savings.

And let's face it, a lot of what you need to be saving for retirement are your future health care expenses. Fidelity's 2010 estimate is that a 65-year old couple will need about $250,000 to pay for health care costs that are above what Medicare covers, and that's actually a conservative estimate of retiree health care costs. Money you sock away money in an HSA ultimately can give you very valuable tax-free dollars to use for health care expenses in retirement.

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