Healthy Savings for the Long Run

Tax-free health savings accounts can ease the burden of medical costs in retirement.

By Kimberly Lankford, Contributing Editor, Kiplinger's Personal Finance

May 2006

Editor's note: This article appears in Kiplinger's special issue Retirement Planning.

One of the biggest expenses facing retirees today is health care. And with employer-provided retiree health benefits on the wane, many a dream of early retirement has evaporated along with them. The harsh reality is that it may be impossible—or impossibly expensive—to buy health insurance on your own in the twilight years between your last paycheck and your first crack at Medicare coverage when you turn 65.

But there is a glimmer of hope as more people gain access to health savings accounts and as the investment options become much better for long-term savers. Tax-deductible HSAs act like IRAs for health expenses. You can tap the accounts now to pay out-of-pocket medical expenses, or stockpile the money to build up a nest egg specifically for health-care costs in retirement. If you spend it on qualified medical expenses, every dime is tax-free.

HSAs could become a crucial tool for future retirees. A new study by Fidelity Investments estimates that a 65-year-old couple retiring today will need $200,000 to cover medical costs in retirement, after adding up Medicare premiums, deductibles, co-payments and other out-of-pocket costs. (And that estimate does not include long-term-care expenses.)

A trifecta of tax breaks

To qualify for an HSA, you must have a high-deductible health insurance policy, either through your employer or on your own. In 2006, the deductible must be at least $1,050 for an individual policy (or $2,100 for a family policy) and meet a few other requirements. Then you can open a health savings account and get a triple tax break. You reduce your current income taxes by setting aside pretax dollars in the account; the money grows tax-free; and withdrawals are tax-free as long as they are used for medical expenses. It’s like combining the best features of tax-deductible contributions to a traditional IRA, tax-free withdrawals from a Roth IRA and the added buying power of pretax dollars in a flexible-spending account.

Your contributions can cut your tax bill significantly. In the 25% federal tax bracket, a $5,000 contribution to an HSA would save you $1,500 in federal taxes. (Additional savings on state income taxes make it an even sweeter deal.) And if your HSA is part of a group plan at work, your deposits also avoid the 7.65% FICA tax that funds Social Security and Medicare.

You can withdraw the money tax-free at any time for medical expenses. But unlike a flexible-spending account, where you must use or lose the money you set aside each year, anything you don’t spend right away can remain in the HSA for future expenses.

A powerful investment

If you start investing $2,700 a year in an HSA when you’re 40, earn 8% per year and don’t touch the money for 25 years, you’ll have more than $200,000 by age 65. If you need the money for medical expenses—and you’ll still have plenty of them after you qualify for Medicare—you’ll have a stash of tax-free money.

It’s your money and you can take it from job to job, like rolling over a 401(k) account from an old employer to a new one. And you can spend it at any time. But if you use it for anything other than medical expenses, you’ll owe income taxes and a 10% penalty on the withdrawal if you’re under age 65. Once you turn 65, you can still spend it on anything. You’ll avoid the 10% penalty at that point, but you’ll still owe income taxes on nonmedical distributions.

“I expect that the money I carry forward into retirement will go for health- care expenses, which can claim a large part of an elderly person’s budget,” says Rebecca Pace, a 49-year-old CPA and financial planner in Cincinnati who has been making the most of an HSA for her own financial planning. “I could even pay Medicare premiums with tax-free distributions.”

1 |
• 2
|
• 3
• NEXT >

• Print
• Comments
• Email
• RSS