Hidden Retirement Savings Opportunity: Health Savings Accounts

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You probably know the drill when it comes to saving for retirement. Put as much money as you can into your 401(k) or IRA, invest wisely, and hope for the best. What many people don’t realize is that there are ways to set aside even more money for your future retirement expenses.

If you’ve maxed out your contributions to your other retirement accounts, a health savings account (HSA) could be another way to squeeze in some extra tax-advantaged savings, potentially offering you the ability to make tax-free contributions, enjoy tax-free investment growth, and make tax-free withdrawals.

Most people can contribute $18,000 to a 401(k) in 2015, plus $5,500 to a traditional or Roth IRA. Yet for some, just saving in a 401(k) isn’t enough. Those who want to go above and beyond the caps on retirement savings, who expect to pay lot for health care in retirement, or who aren’t eligible to contribute to traditional or Roth IRAs because of income limits, could accumulate a significant amount of money that could be used for health care of other retirement expenses with an HSA.

Consider this: If you contribute the maximum amount to an HSA for 10 years, you could end up with $60,000 (assuming your rate of return is 5% and that you make no withdrawals), according to research by the Employee Benefit Research Institute. Contribute the maximum for 40 years, and you could have $600,000 by the time you retire.

Health savings accounts can be a great way to save a bit more for the future, but they have certain quirks. Before you get started, it’s important to understand how HSAs work, specifically when it comes to retirement.

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Health savings account basics

HSAs were created in 2003 as a way to help people with high-deductible health plans (HDHP) set aside pre-tax money for out-of-pocket health care costs. Any plan with an annual deductible of at least $1,300 for individual coverage and $2,600 for family coverage is considered an HDHP. Once you enroll in an HDHP, you can open an HSA and start contributing money — up to $6,650 in 2015 if you have family coverage and $3,350 if you have individual coverage (those older than 55 are also eligible for a $1,000 catch-up contribution).

Anyone who is covered by a high-deductible health plan can contribute to an HSA, provided you aren’t someone’s dependent, enrolled in Medicare, or covered by another health plan. Also, unlike other tax-advantaged accounts, like IRAs, you can make deductible contributions to an HSA no matter how high your income.

Any money you contribute to your HSA can be deducted from your taxes, even if you don’t itemize. Plus, unlike the similar-sounding flexible spending account (FSA), there’s no use-it-or-lose-it provision with HSAs; instead, the money rolls over from year to year. Any interest or return on your investments is also free of tax, potentially allowing you to accumulate some pretty significant savings. Those combined benefits have made the accounts popular with consumers, who had more than $20 billion in HSAs at the end of January 2014, according to independent HSA investment adviser Devenir.

What’s the catch? Once you’ve put money into your HSA, you’re only allowed to use it for qualified medical expenses, which include everything from acupuncture treatments to vision correction surgery (but not things such as cosmetic surgery or health club dues). If you withdraw money from your HSA and don’t use it for medical expenses, you’ll pay tax on the distribution, plus a 20% penalty. But that all changes once you reach 65. At that point, you can withdraw money from your HSA for non-health care expenses and not have to pay the 20% penalty, though you will pay regular tax on those withdrawals. If you use the money for health care costs in retirement, it’s still tax-free.

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HSAs and your retirement

Only 17% of workers surveyed by the Employee Benefit Research Institute in 2014 were confident that they’d have enough money to cover their medical expenses during retirement. Concerns about retiree health care costs are well-placed, given how much of your savings both routine and unexpected health care expenses can eat up. The average 65-year-old couple retiring today will pay an estimated $220,000 for health care in retirement, according to research by Fidelity.

For anyone who is wondering whether they will have enough to pay for health care in the future, contributing to an HSA can be a way to ease those concerns. A well-funded HSA can provide the cash you might need for medical expenses after you stop working, especially those that aren’t covered by Medicare: think long-term care, dental and eye exams, and hearing aids.

You can even use money in an HSA to pay for long-term-care insurance premiums. Plus, given the triple tax benefits — you pay no tax on either contributions, growth of your assets, or withdrawals — an HSA can be a way for your stretch your savings even further.

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