Healthy Savings for the Long Run

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.

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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.”

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Save at work

If you’re still working, your employer may offer an HSA-eligible health insurance plan among its options during open-enrollment season. Do the math to figure out whether it’s the best plan for you. You’ll benefit from lower premiums for the high-deductible plan and lower taxes because your HSA contributions are tax-deductible.

If your company offers a savings account to pair with your high-deductible health insurance policy, it will make administration easier and may cut costs if they subsidize some fees. Your boss might even add some money to the savings account, too. But if you don’t have an HSA option at work, you can open an account on your own (see the box for ways to check out the fees and investment options).

When choosing the investments, decide how you’re going to use the money. Most plans require you to keep up to $1,000 or $2,000 in a money-market account—generally paying 2% to 3% interest—so the money is accessible in case you need it for current medical expenses. But if you have enough cash to pay your health-care costs with other funds, you’ll reap bigger tax benefits if you toss out your HSA’s debit card and keep the money in the HSA for the long haul. In that case, you’ll need investments to match your longer time frame.

Some employer plans are starting to offer mutual fund investment options inside their HSAs. WageWorks, which administers HSAs and other employee-benefit plans for employers, offers a diversified portfolio of funds from Artisan, Dodge & Cox, Harbor, Vanguard and Victory. Keep enough cash in the HSA’s money-market account to cover any emergency medical expenses, then invest the rest as you would in other retirement accounts.

Keep an eye out for better investment options every few years. Fidelity is starting to get into the HSA business, which should encourage more competition for good, affordable investment choices.

Early-retirement solution

Early retirees need more help with medical expenses than almost anyone else. Few have retiree health coverage, and those who search for their own policies can be rejected or charged high prices if they have any medical conditions.

If your employer doesn’t offer retiree health coverage, you may be able to remain on the company plan for up to 18 months under COBRA, a federal law that lets you continue group coverage after you leave the group. But you will have to pay the entire bill yourself—which can be a real shock if your employer subsidized a big chunk of your coverage. The average employee pays $2,713 per year for family coverage, according to the Kaiser Family Foundation. But the average employer pays nearly 75% of the total cost. If you have COBRA coverage, you have to pay the full bill yourself—bringing the average premium up to about $10,880, plus up to 2% in administrative expenses.

If you’re in poor health, COBRA may still be your best bet because you can’t be denied coverage under a group plan. In that case, any money you’ve already set aside in an HSA can come in quite handy. You can use HSA money to pay for COBRA premiums and out-of-pocket costs. And if your employer offers an HSA-eligible, high-deductible COBRA policy, you may still be able to contribute money to your HSA.

If you’re healthy, though, you may get a better deal by buying a policy on your own. Buying a high-deductible plan may be a great way to trim your premiums, and contributing to the HSA can lower your tax bill. If you’re 55 or older, you can contribute an extra $700 to the account in 2006—in addition to the $5,450 for families or $2,700 for individuals.

You can’t use your HSA money to pay health-insurance premiums (except for COBRA coverage), but you can use it to pay your deductibles, co-payments and expenses that aren’t covered by insurance—such as vision and dental care. You can also use it to pay for prescription drugs and most over-the-counter medications for yourself, your spouse and your dependents. For a full list of eligible HSA expenses, see IRS Publications 969 and 502, available at www.irs.gov or by calling 800-829-3676.

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HSAs in retirement

While you can’t continue to contribute to an HSA once you turn 65 and sign up for Medicare, there are plenty of things you can spend the money on. And even though you can use the HSA money for anything without a penalty after age 65, you’ll get a much bigger bang for your buck if you use it for medical expenses; you’ll have no penalty or tax bill.

You can continue to use your HSA money to pay for medical expenses, co-pays and deductibles that aren’t covered by insurance as well as for premiums for Medicare Part B (which costs $1,062 in 2006), Medicare Advantage plans, Part D prescription-drug coverage and qualified long-term-care insurance premiums. The one exception: You can’t use the money to pay medigap premiums.

On your own

If you don’t have health insurance through work—or if you aren’t happy with your employer’s plan—a high-deductible policy with an HSA can be a great option. The high deductible can lower your premiums—and save you even more money in years when you have few medical expenses—and the tax benefits can help you stretch the dollars even further. If you’re healthy, buying an individual policy may be less expensive than you’d expect.

That was the case for financial planner Rebecca Pace. Pace had coverage through her former husband’s employer. But when she and her husband divorced, she wasn’t certain she could continue to be self-employed. She worried that she’d have to find a new job just to get health insurance.

Pace could have kept coverage on her ex-husband’s plan for up to 36 months because of COBRA. But she worked with a local health-insurance broker and found a much better deal on her own. Now she’s paying $132 per month for an HSA-eligible policy with a $4,000 deductible through Anthem Blue Cross/Blue Shield. “I was surprised it was that low,” she says.

The health-insurance company offered its own HSA, but Pace wasn’t happy with the fees and investment choices. So she went online to HSAFinder.com to search for another HSA administrator. She found a deal she liked at Capitol Bank of Wisconsin and signed up. She made the maximum contribution to the HSA and keeps the money in a money-market account for now. As she amasses more money inside the HSA, she will probably shift some of it to mutual funds. “I’m a pretty healthy person, so I’m hoping I can carry over a lot of money to next year,” she says.

Going forward, Pace says she’ll try to use other money for medical expenses and keep even more cash in the account for health-care costs in retirement. Plus, she’ll reap even bigger tax benefits. “I have longevity in my family—my father just turned 97—so I expect to need this account for a long time,” she says.