Health Savings Accounts (HSAs) provide significant tax benefits for savers planning for retirement and Medicare.
However, like any financial tool, there are specific strategies and limitations to consider when using an HSA as you transition into Medicare.
This article provides a straightforward look at how to maximize the value of your HSA in retirement.
Understanding HSA Rules and Penalties in Retirement
HSA Withdrawal Penalties Go Away at Age 65
Health savings accounts are often the best way by far to save money to pay future medical expenses.
The triple tax advantage that HSAs offer can’t be beat:
- Pre-tax contributions
- Tax-deferred growth
- Tax-free withdrawals to pay qualified medical expenses
The catch? You really want to use them for qualified medical expenses listed in IRS Publication 502 – Medical and Dental Expenses. Otherwise, you face a nasty 20% tax penalty on any non-qualified withdrawal.
And you have to pay income tax on top of that – even on the 20% you got penalized.
The good news, though, is that the penalty doesn’t stick around forever. As soon as you turn age 65, the 20% penalty disappears.
At that point, you can withdraw HSA funds for any reason at all without penalty.
Non-medical withdrawals from HSAs are still subject to income tax. But that’s true of IRAs and 401(k)s, too. Once you turn 65, your HSA becomes a very versatile and powerful financial asset: You can still use it to pay medical bills with tax-free dollars. But you can also use it to supplement your retirement income.
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Let Your HSA Grow
If you don’t need the funds immediately, leave your HSA alone.
As long as your money remains in the account, all the growth will be tax-free. And unlike traditional IRAs and 401(k) accounts.
HSAs don’t have required minimum distributions. If you don’t need the money for medical expenses or for immediate living expenses, you can continue to let it grow unmolested as long as you live.
Pay Medical Bills With Tax-Free Dollars
Any qualified healthcare expenses in retirement can still be paid tax-free from your HSA account. Just keep records of what you use the money for, and keep any doctors’ bills, receipts, and invoices so that you can defend yourself against an audit.
Additional Uses for HSA Funds
HSA funds aren’t limited to doctor and hospital bills. You can also make tax-free withdrawals for certain expenses like long-term care insurance premiums, medical travel, medically necessary modifications to cars and custom vans, and even home modifications to accommodate disabilities.
HSA Withdrawal Rules After Age 65
| Use of Funds | Penalty | Tax Implication |
|---|---|---|
| Qualified Medical Expenses | None | Tax-Free |
| Long-Term Care Premiums | None | Tax-Free |
| Non-Qualified Withdrawals | None | Subject to Income Tax |
What Can You Spend HSA Funds On in Retirement?
HSAs are flexible, but strategic spending is key to maximizing their value. Here are some practical uses of your HSA in retirement:
- Medical Travel: Cover travel and lodging expenses for medical treatments.
- Home Modifications: Fund modifications to improve accessibility in your home.
- Hearing Aids and Dental Costs: Pay for hearing aids, dentures, and other out-of-pocket health expenses.
- Prescriptions: Cover prescription drugs, a significant expense for many retirees.
HSA Spending Do’s and Don’ts in Retirement
As you shift to Medicare, there are a few important rules to follow when using your HSA to avoid common mistakes.
HSA “Do’s”
1. Let Your HSA Continue to Grow
Leave your HSA alone as long as you can to keep it growing tax-deferred. Use it only for qualified medical expenses if possible.
2. Supplement Income if Needed
While HSAs are best used for medical expenses, they can also provide additional income if needed.
Just remember, medically qualified withdrawals are tax-free, while non-medically qualified withdrawals are taxed as income.
3. Pay Long-Term Care Insurance Premiums
Your HSA can cover long-term care insurance premiums tax-free, up to specific limits that increase with age.
This can be a smart way to protect yourself from high long-term care costs down the road.
4. Use HSA Funds for Medical Travel and Lodging
If you require medical treatment far from home, your HSA can cover travel and lodging expenses related to that treatment.
5. Home and Vehicle Modifications
You can tap HSA funds tax-free to purchase necessary modifications to a car, van, or home to accommodate your disabilities.
HSA “Don’ts”
1. Don’t Use Use Your HSA for Medigap Premiums
Medigap premiums aren’t considered qualified expenses for HSA purposes.
Attempting to use your HSA to pay for Medigap could lead to tax penalties if deducted improperly. You can still make the withdrawal, assuming you’re at least 65 years old. But your withdrawal will be taxed at your ordinary income rate.
But as you get older, chances are good you’ll have other medical expenses that would be a better use of those funds, because those expenses allow you to take advantage of the HSAs most powerful advantage: Tax-free withdrawals to pay medical expenses.
2. Don’t Use HSAs to Pay DPC Fees or Health Sharing Contributions
Health sharing plan fees and direct primary care (DPC) memberships aren’t HSA-qualified expenses.
So your withdrawal would be fully taxable at ordinary income rates. Stick to approved expenses to maximize your HSA benefits.
3. Avoid Non-Qualified Withdrawals Without Medical Necessity Documentation
For any expense you intend to deduct as medically necessary, ensure you have a letter of medical necessity from your provider.
And keep all your receipts and invoices.
This documentation can be essential if there’s any question about a claim.
WARNING: Watch Out for the Inherited HSA Tax Trap
While HSAs are a fantastic, versatile asset to own as you head into retirement, there is a potential pitfall you should be aware of:
Inherited HSAs are not treated very well under the tax code:
Unlike IRAs, which can often be inherited by a spouse or passed to heirs with very favorable tax treatment, inherited HSA balances are fully taxable as income to your non-spouse heirs.
That can lead to a nasty tax hit.
In contrast, had they inherited a life insurance death benefit, they would have received the cash tax-free on your death.
Likewise, had they inherited an IRA rather than an HSA, they could spread their inheritance over up to ten years. This lowers the eventual income tax hit substantially.
To avoid leaving a large HSA balance that could create tax complications for your family, consider a Deathbed Drawdown Strategy.
This approach involves drawing down your HSA funds in the final years of life to cover medical or other qualified expenses, allowing you to enjoy the tax advantages yourself and reduce the tax burden for your beneficiaries.
Learn More: How to Avoid the HSA Tax Trap: An Introduction to the Deathbed Drawdown Strategy
Publication 502—A Valuable Resource for HSA Owners
IRS Publication 502 provides extensive details on what counts as a qualified medical expense, including travel, lodging, and modifications to accommodate disabilities.
Reference this publication when considering how to use your HSA funds and consult a Personal Benefits Manager (PBM) for additional guidance on tax rules.
Recommended HSA Uses in Retirement
| Expense | Qualified Medical Expense? | Tax Treatment of HSA Withdrawals |
|---|---|---|
| Long-Term Care Insurance | Yes | Tax-Free |
| Medical Travel and Lodging | Yes | Tax-Free |
| Medigap Premiums | No | Taxable at ordinary income rates |
| Direct Primary Care Fees | No | Taxable at ordinary income rates |
| Health Sharing Plan Contributions | No | Taxable at ordinary income rates |
| Home/Vehicle Modifications | Yes | Tax-Free |
Why Work With a Personal Benefits Manager (PBM)
Navigating HSA rules and making the best choices as you transition to Medicare isn’t always simple.
A PBM can help you evaluate plan options, understand HSA spending limits, and determine the best ways to use your funds for long-term care, disability accommodations, and other expenses.
At Medigap Advisors, our PBMs specialize in helping retirees make the most of their healthcare dollars, whether it’s signing up for the right Medicare plan, buying long-term care insurance, or making qualified withdrawals from an HSA.
HSA and Long-Term Care Planning
Given the rising costs of long-term care, using an HSA to cover long-term care premiums is a smart move.
Most retirees are surprised to find that long-term care is one of their largest expenses, and planning ahead can reduce the impact on their retirement funds.
Purchasing a long-term care policy with HSA funds can keep you financially secure while covering essential services.
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What To Do Now
HSAs offer retirees a unique blend of flexibility, tax advantages, and healthcare savings, making them a powerful tool for anyone transitioning to Medicare.
To make the most of your HSA in retirement, work with a Personal Benefits Manager (PBM), who can provide expert advice on how to manage healthcare costs while minimizing taxes.
If you’re concerned about future healthcare needs, it’s also wise to consider buying long-term care insurance. A PBM can provide you with a quote and help you secure coverage tailored to your needs.
HSAs are still valuable in retirement, especially when combined with Medicare planning and long-term care insurance. Maximize the advantages of your HSA by taking steps now to ensure a financially secure future.
For Further Reading
Whitney Kline is one of your Personal Benefits Managers at Medigap Advisors. She loves working for Medigap Advisors especially helping clients choose the right Medicare plan.