This retirement savings account can be a super-IRA

Looking for tax-advantaged retirement savings? A health savings account (HSA) beats both an IRA and nonmatched 401(k) contributions, provided you're eligible. Let's see why.

What's an HSA?

It's an investment account meant for paying qualified medical expenses (defined below). You're eligible to contribute to an HSA only if you participate in a high-deductible health plan (HDHP) and aren't enrolled in Medicare. For 2016, an HDHP is one with at least a deductible of $1,300 for a single person and $2,600 for family coverage.

The maximum amount you can contribute to an HSA in 2016 is:

  • $3,350 for single coverage
  • $6,750 for family coverage
  • Plus a $1,000 catch-up contribution if you're 55 or older

Contributions are deducted from your gross income when calculating your net income for the purposes of federal and state income taxes.

Why is this such a great tax-advantaged investment?

Contributions to an HSA are invested and accumulated tax-free until you withdraw money from the account. If you withdraw to pay qualified medical expenses, no income taxes are due at the time of withdrawal. In this instance, you avoid altogether and forever any income taxes on the amounts invested in an HSA. From a pure tax perspective, this beats contributions to a 401(k) plan or an IRA because with these plans, you'll have to pay income taxes sooner (with a Roth 401(k) or IRA) or later (with a deductible 401(k) or IRA).

No other retirement savings vehicle offers these tax advantages. The only retirement savings opportunity that's better than an HSA would be matching contributions from your employer to your 401(k) plan or IRA. If that option is available to you, you should contribute the maximum that's matched first, then consider contributing as much as you can to an HSA.

Where can you invest in an HSA?

Many employers package an HDHP with an HSA. That makes contributing to an HSA easy, with automatic payroll deduction and the company doing the investment shopping for you. If you're self-employed and participate in an HDHP, you can also set up an HSA with many financial institutions. You can typically invest in a variety of mutual funds or bank accounts.

What are qualified medical expenses?

You can withdraw money from an HSA at any time to pay for qualified health care expenses, including:

  • Medical, dental, prescription drug and vision expenses, including any deductibles and co-payments
  • Premiums paid after age 65 for Medicare or your employer's retiree medical plan (but not for Medicare supplement plans)
  • COBRA premiums
  • Long-term care services
  • Premiums for qualified long-term care insurance

If you withdraw money from your HSA to pay for a qualified expense, you'll receive the tax advantages identified above. Some people may hesitate to contribute to an HSA, thinking they won't be able to eventually spend all the money on qualified medical expenses. Think again. Given all the uses listed above, it's very likely that you can spend tens or even hundreds of thousands of dollars on these expenses during the rest of your life.

You're also allowed to withdraw from an HSA to pay for expenses that aren't qualified medical expenses, but you'll pay ordinary income taxes on that money, and you'll be assessed a 20 percent penalty if you're under age 65.

Why would an HSA be considered a super IRA?

HSAs have a few significant advantages over IRAs and nonmatched 401(k) plans:

  • You can withdraw penalty-free from an HSA to pay for qualified medical expenses at any age, whereas IRA withdrawals are typically assessed a 10 percent early-withdrawal penalty before age 59-1/2.
  • Once you reach age 65, you can withdraw money from an HSA penalty-free to pay for expenses that aren't qualified medical expenses. In this case, you'll pay ordinary income taxes, which is the same outcome for any withdrawals from deductible 401(k) plans and IRAs.
  • HSAs have no IRS required minimum distribution (RMD) at age 70-1/2, whereas 401(k) plans and deductible IRAs are subject to such rules.

In essence, you have maximum flexibility with an HSA. You can:

  • Use it while you're working to pay for medical expenses you incur during the year or any future year.
  • Let it accumulate to pay for qualified medical expenses when you retire.
  • Let it accumulate until after you've attained age 65 to pay for expenses that aren't qualified medical expenses, and then pay ordinary income taxes on the withdrawal.

How should you invest the money in an HSA?

Your HSA withdrawal strategy will influence your investment strategy. If you plan to use an HSA account to pay for current medical expenses, you'll want to avoid substantial stock market investments that can decline at any time and look for liquid investments that conserve principal.

On the other hand, if you plan to use your HSA contributions to pay for medical expenses in retirement, you might have a long investing horizon that can justify substantial stock investments. In particular, it's possible to delay using an HSA account until your 80s, when you might have high medical or long-term care expenses. That would give you a very long investing horizon.

The bottom line: If you're eligible, HSAs offer great tax advantages and flexibility. Many people who are eligible should consider first maxing out any matching 401(k) or IRA contributions, then max out HSA contributions and then max out nonmatched 401(k) or IRA contributions.

You'll have to put some thought into this strategy to make it work in your favor, but you'll be glad you did.

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    Steve Vernon helped large employers design and manage their retirement programs for more than 35 years as a consulting actuary. Now he's a research scholar for the Stanford Center on Longevity, where he helps collect, direct and disseminate research that will improve the financial security of seniors. He's also president of Rest-of-Life Communications, delivers retirement planning workshops and authored Money for Life: Turn Your IRA and 401(k) Into a Lifetime Retirement Paycheck and Recession-Proof Your Retirement Years.