I am not a big gambler. However, I do have enough experience playing nickel slots in Vegas (I am a real high-roller when I do gamble) to have learned that it is easy to get two sevens on a classic three-column slot machine but almost impossible to get three (777) and win the jackpot. This is by design. The casinos want you to believe that you are very close to hitting the jackpot that almost never comes.
Like a three-column slot-machine saving for retirement using IRAs also has three phases, the contribution phase, the accumulation phase, and the withdrawal phase. In each of these phases you are either exempt from tax (E) or taxed (T). Hitting the IRA jackpot would mean being exempt from tax in all three phases (EEE).
Like Vegas the government makes it easy to get an E in two of the three columns but much more difficult to get an E in all three columns and hit the IRA jackpot. While it is difficult to get EEE it is not impossible to do so with at least some of your retirement savings. Let’s take a closer look at how this can be done.
Traditional and Roth IRAs
The traditional IRA is tax exempt when you contribute to it (your taxable income is reduced by the amount of your contribution), and tax exempt during accumulation, but taxable when you withdraw your money. With a traditional IRA your slot machine looks like this: EET.
A Roth IRA reverses this. You are taxed on the amount you contribute (you contribute with dollars you have already paid taxes on), but the accumulation and withdrawal phases are exempt from taxes. With a Roth IRA your slot machine looks like this: TEE.
A Well-Disguised Third Option
Most people think these are your only two options and it is impossible to get EEE and win the IRA jackpot. Not true. There actually is a way to get EEE, but like a casino, the government doesn’t make hitting the jackpot easy.
The first method the government uses to reduce the odds of you hitting the IRA jackpot is to provide a clever disguise for the instrument that exempts you from taxes in all three phases of the retirement life cycle. The disguise consists of hiding this powerful tool in plain sight, but under an assumed name. The government doesn’t call it an IRA at all, but instead calls it a Health Savings Account (HSA). To make its true identity plain I like to call it a Health Care IRA.
Health Savings Accounts
Can a Health Savings Account really make part of your retirement savings completely exempt from taxes? In the words of the Genie when Aladdin asks if he is really going to grant him any three wishes he wants: “Ah, almost. There are a few provisos, a couple of quid pro quos.” In our case there are also some restrictions, limitations and hoops to jump through.
- First, you have to be enrolled in a High Deductible Health Plan as defined by the IRS. For 2017 this is a health plan with a minimum deductible of $1,300 for an individual ($2,600 for a family) and a maximum deductible of $6,550 for an individual ($13,100 for a family).
- If you are enrolled in a high deductible health plan you can open an HSA. Maximum contributions in 2017 are $3,400 for an individual ($6,750 for a family). These contributions are tax exempt (contributions lower your taxable income).
- If you withdraw money from your HSA for any reason other than to pay for qualified medical expenses then, in addition to paying regular income tax on the distribution, there is also a 20% penalty. This penalty applies until you reach the age of 65. Therefore, don’t contribute any money to an HSA unless you are prepared to use it only to pay for medical expenses.
If you follow these rules than withdrawals from an HSA to pay for qualified medical expenses are tax exempt. This gives you the IRA jackpot of EEE, exempt on contribution, exempt on accumulation, and exempt on withdrawal.
Why does the IRS allow this? My guess is that they assume there will not be a long period of time for your money to grow between contribution and withdrawal. However, the IRS has not placed a time limit on how long you can leave money in an HSA, which is the opening you need to hit the IRA jackpot.
To get the maximum benefit from this opening you will want to let money grow in your HSA for as long as possible. That is why I like to think of an HSA as a Health Care IRA. If your financial situation allows you should think of this money the same way you do an IRA and not touch it until retirement. To do this you will need to pay for out-of-pocket medical expenses with money separate from your HSA.
A Word of Caution
The money in your HSA is there for medical expenses. If you need medical care that you cannot afford without using the money in your HSA absolutely, positively do not hesitate to withdraw the money to pay for the medical care. Your health is far more important than accumulating money in a Health Care IRA. If you lose your health your retirement will be compromised no matter how much money you have saved up. Protecting your health is your first priority.
HSA Example
Imagine that each year you get a $5,000 dollar bonus. You decide the best use of this bonus is to save for retirement. If you contribute the $5,000 to a traditional IRA your taxable income and tax liability remain what they were prior to the bonus, so you can contribute the entire $5,000.
If you choose a Roth IRA instead, and you are in the 25% federal tax bracket, your taxable income will increase by $5,000 and you will owe $1,250 more in taxes (5,000 x 25%) which means you can only contribute $3,750 each year ($5,000 less $1,250).
After 20 years you will have contributed $100,000 to the traditional IRA ($5,000 x 20), but only $75,000 to the Roth IRA ($3,750 x 20). Let’s also imagine during this 20 years that you doubled the money you contributed, which could be accomplished with a reasonable investment return of under 7% per year. This would give you $200,000 in a traditional IRA, but only $150,000 in the Roth IRA.
Now suppose you retire. You could withdraw the entire $150,000 from the Roth account during retirement tax-free, giving you the entire $150,000 to spend. With the traditional IRA, assuming you were still in the 25% tax bracket, you would have to pay 25% of any withdrawals in taxes. This would also give you $150,000 to spend during retirement. Notice that if your tax rate is the same when you withdraw as when you contribute there is no relative advantage to either a traditional or Roth IRA. The result is identical.
Suppose, instead, you had used the $5,000 bonus to fund a health savings account each year. The money would be tax-exempt when contributed, meaning you could contribute the entire $5,000. With the same investment return as above this would give you $200,000 in your HSA as you entered retirement.
However, if the money is spent on qualified medical expenses withdrawals will also be exempt from taxes. That would give you the full $200,000 to spend on health care during retirement, which is a $50,000 increase over the spending power of either the traditional IRA or Roth IRA. Now that is a jackpot worth getting excited about.
How Much Will You Need for Health Care in Retirement?
Money in an HSA is only exempt from taxes on withdrawal if it is used to pay for qualified medical expenses. So, will you really need $200,000 for medical expenses in retirement?
Unfortunately, probably yes. Fidelity recently estimated that a 65-year-old couple will spend $245,000 on health care costs during retirement. That sounds like a lot, but during a 20-year retirement it is only about $12,000 per year, and odds are at least one of you will have a retirement significantly longer than 20 years.
The worst case scenario is that you will remain healthy and not need a portion of the money in your HSA for medical expenses – a worst case all of us would welcome. In this situation you wouldn’t get the entire $50,000 jackpot, as the money not used for healthcare would be taxed as ordinary income upon withdrawal, similar to withdrawals from a traditional IRA.
Consult your own tax genie to see if using an HSA as a Health Care IRA is a wise move for you. For many the tax advantages available only through an HSA make them a very powerful tool for supplementing retirement savings. After all, you don’t get many chances in life to beat the house and win a $50,000 jackpot.
Note: For more information about Health Savings Accounts read IRS publication 969.
I like your comparison to a slot machine. The government is going to get their money someway. I miss my high deductible insurance plan at my old employer. Since I rarely go to the doctor, it made a lot of sense to me. Additionally, my company matched contributions to an HSA account dollar for dollar up to $1,200 for an individual. You can build up a nice sum in your HSA account that way.
Thanks for sharing this. I think HSA’s are often overlooked by many people.
An HSA with a company match is perhaps the best deal there is in saving money. You really can’t beat no taxes and a match.
Brent,
I love the slot machine analogy. An HSA is not something I’ve considered until recently because it wasn’t available at my previous company, but I may go this route at open enrollment in my new position.
I haven’t done a ton of research on HSAs yet, but it’s my understanding that any medical care that I pay out of pocket now but don’t take the withdrawal for now can be claimed at a later date as long as documentation can be presented to justify the withdrawal. This seems like the best case senario.
I pay for small expenses throughout my working years out of pocket without taking a withdrawal from my HSA & then take the withdrawal tax free in retirement even if I have no current medical expenses.
I can hear the slot machines ringing with EEE tax free withdrawals in my future.
Thanks for the this.
You are correct. There is no time limit between when you incur the expense and when you can withdraw the money from your HSA as long as the expense was incurred after the HSA was established, it was not previously reimbursed, and you did not deduct the expenses as an itemized deduction in a previous year. Here is the guidance from IRS Bulletin 2004-33, Question 39:
“Q-39. When must a distribution from an HSA be taken to pay or reimburse, on a tax-free basis, qualified medical expenses incurred in the current year?
A-39. An account beneficiary may defer to later taxable years distributions from HSAs to pay or reimburse qualified medical expenses incurred in the current year as long as the expenses were incurred after the HSA was established. Similarly, a distribution from an HSA in the current year can be used to pay or reimburse expenses incurred in any prior year as long as the expenses were incurred after the HSA was established. Thus, there is no time limit on when the distribution must occur. However, to be excludable from the account beneficiary’s gross income, he or she must keep records sufficient to later show that the distributions were exclusively to pay or reimburse qualified medical expenses, that the qualified medical expenses have not been previously paid or reimbursed from another source and that the medical expenses have not been taken as an itemized deduction in any prior taxable year. See Notice 2004-2, Q&A 31 and also Notice 2004-25, for transition relief in calendar year 2004 for reimbursement of medical expenses incurred before opening an HSA.”
As far as I know this is still the current position of the IRS.
I love the idea of an HSA as a retirement savings vehicle, but I don’t like that a lot of them come with fees. Typically the savings account is free, but if you want to invest the money, it’s a flat fee which is more painful on a smaller balance. Once the balance gets big enough the fee becomes a smaller and smaller percentage of your overall balance. For now I’m staying in the savings account in my HSA because the fees would offset most investment gains.
If you have any health expenses in a given year, how do you pay for them?
How high is the fee? If you are planning on leaving money in the HSA for decades I would be shocked if the fee was so high that you wouldn’t come out far ahead investing the money instead of leaving it in a savings account. I hate high fees too, but it still might be your best option.
Aside from the using $5,000 in your example not being attainable (due to the $3400 limit on HSA contributions), I agree 100% with it all.
I saw the potential future benefits the first year my employer offered the HDHP with HSA.
I’ve maxed out my HSA contributions every year and never taken out a cent. My HSA has just under $50K in it now.
I have it set up in my retirement planning spreadsheet to be the last account I take anything out of (except medical expenses) after I retire.
If it works out the way I plan, I won’t ever pay any taxes on the money I use to pay medical expenses.
I was assuming a family being covered under the plan, not just an individual. For a single individual you are correct that $5,000 would be above the limit. I should have made that clear. Thanks for pointing that out. And great job on the $50k you have saved.