Should You Use an HSA for Retirement Savings

Should you use a Health Savings Account (HSA) to save for retirement? That’s the question a listener to the Dough Roller Money Podcast asked recently. Here’s Mike’s email:

Hi Rob, I have a question about my HSA at work. I have about $14,000 in it. I have not used it at all in the past as I have not had any significant medical expenses. This year I have medical expenses of about $5000. I have already paid the medical bills with non-HSA money. I would like to leave all of the money in my HSA year after year until I retire and use that money as a pseudo-retirement account. My question is should I withdraw the $5,000 from my HSA this year to cover my medical expenses? If I pay for the medical expenses with HSA dollars then I am paying with pretax money and therefore saving on the cost of the medical expenses. But then I lose the benefit of tax-free earnings over the next 15 years or so before I retire.

Here are some details about me in case they are relevant in this decision. I am 47 years old. I am fully funding my 401(k) at work and have some taxable mutual fund investments through Vanguard. I have not invested in an IRA yet but this is the first year I plan to do so. I am single and my income is about $150,000 per year.

One other question When I open up my IRA this year, should I open up a Roth IRA or a traditional IRA?

Thanks for your Podcasts. I really enjoy them. By listening to them I feel like I am getting a degree in personal finance and investing for free.

Mike

I've covered my views on the Roth IRA vs traditional IRA decision, which you can check out in Podcast 90. Mike's question about his HSA is an important one, particularly for those who want to save more for retirement than allowed by a 401k and IRA.

Like so many personal finance choices we face, there is no clear "right" or "wrong" answer here. Instead, the best approach will vary from person to person and depend, in large part, on an individual's financial goals. With that said, let's look at using an HSA for retirement, along with the advantages and disadvantages of this approach.

HSA--A Quick Refresher

An HSA enables those with a high deductible health insurance policy to save money on a tax-free basis. Contributions to an HSA are pre-tax, and withdrawals for medical expenses are tax-free as well.

Unlike a flexible spending account, the funds in an HSA do not have to be spent each year. They can be accrued from year to year until retirement. Money can be withdrawn for non-medical reasons at age 65 without penalty, although the withdrawals will be taxed at ordinary income rates. These features make an HSA a potential retirement savings option.

Understand Your Options

At first glance, the options may seem obvious. Mike can either use the HSA money to pay for his medical expenses or keep the money in the tax-deferred account and use out-of-pocket money. What can often be overlooked, however, is a third option--using a combination of both approaches.

For example, he could decide to use $2,500 of the HSA funds to pay his medical bills, while paying the remainder from his after-tax money.

Read: The Lowdown on Health Savings Accounts as Retirement Savings Vehicles

What’s the Best Use of the Money?

A key question is how Mike will use the $5,000 out of pocket if he uses his HSA funds to pay the medical expense. In effect, we are trying to determine the highest and best use of the money (the true and elusive definition of "cost of capital," by the way). While this will vary from one individual to the next, here are some potential uses of the money:

Invest in an IRA (traditional or Roth)
Invest in taxable account (if one has already maxed out IRA)
Pay down debt
Fund a 529 plan
Bulk up an emergency fund

One comment about the above list. If you are not maxing out your 401k and IRA, there's no reason to use your HSA as a retirement account. That said, the best approach will depend on your specific circumstances and financial goals.

What are your goals?

For Mike, his goal may be to maximize his retirement savings. If he's fully funded a 401k and IRA, keeping the money in his HSA may be the best way to maximize his tax-advantaged retirement savings.

For others, the primary goal may be to get out of debt. In that case, it may be better to use the HSA funds for the medical expenses and apply the $5,000 to high interest credit card debt.

Advantages

There are two key advantages to using an HSA for retirement:

Enables one to save more for retirement in a tax-advantaged account
The money in an HSA can be used for medical expenses at any time, if necessary

Disadvantages

There also are some disadvantages:

Investment options in some HSAs are not very good
The money can't be withdrawn for non-medical expenses without penalty until age 65
The money placed in an HSA can't be used for other purposes, like getting out of debt