Move over IRAs. HSAs are muscling into your retirement savings turf, at least according to asset-management giant Vanguard.
What, you're probably thinking, does a health savings account (HSA) — which is designed to pay for medical expenses like copays and deductibles — have to do with saving for your Golden Years?
A lot, it turns out. In fact, an updated study from Vanguard says budget-constrained savers should fund an HSA account before any type of IRA. "HSAs are a valuable and underappreciated tool for retirement," said Sabino Vargas, a senior financial planner at Vanguard.
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HSAs Grow Up For Retirement Savings
What investors once considered to simply be medical checking accounts may become a long-term retirement account. That's why Vanguard wants investors to take another look at HSAs and consider them a second-best tool when funding accounts for retirement, says Vargas.
In 2023, you can contribute up to $3,850 in an HSA if you have single health coverage and $7,750 for family coverage. Those older than 55 can contribute an additional $1,000. In 2024, HSA contribution limits rise to $4,150 for single coverage and $8,300 for families, although there's no increase in catch-up contributions. HSAs are only available to those who enroll in a High Deductible Health Plan (HDHP).
Prioritizing Retirement Savings
When it comes to retirement readiness, prioritizing how much to save and the right account type are key, according to Vanguard. Here's the pecking order of accounts the investment firm recommends for savers looking to maximize each next dollar they can stash away for retirement.
First, contribute to an employer-sponsored plan, such as a 401(k). Put in at least up to the amount that ensures you get your full matching contribution from your employer. "You don't want to leave money on the table," said Vargas.
Next, contribute to an HSA. Why? There are two key benefits of HSAs.
Perk one of HSAs: They offer a triple-tax advantage that other account types don't. All HSA contributions go in tax-free, grow tax-free and can be withdrawn tax-free if used for qualified medical expenses.
Two, HSAs offer added flexibility IRAs don't. Examples include contributions not being subject to income limits or phaseouts, as well as reimbursement rules that can help boost the growth potential of your invested assets. Another plus: HSAs, like IRAs, don't have a use-it or lose-it rule, as do flexible spending accounts (FSAs). You can roll over your savings in an HSA from year to year which helps grow your nest egg.
Third comes tax-advantaged accounts like traditional and Roth IRAs and college savings accounts. These account types are farther down the list because they benefit from only two tax breaks not three like HSAs.
Finally, fund taxable accounts.
HSAs Beat Out IRAs For Retirement Planning
Why do HSAs rank above IRAs for retirement planning? Unrivaled tax advantages for one thing.
With other tax-advantaged retirement accounts, you're either going to pay taxes now or later. With a Roth IRA, for example, your contributions are made with dollars already taxed by the IRS. And with traditional 401(k)s and IRAs, you pay taxes when you make withdrawals.
No doubt, it's the unique tax benefits of HSAs which make this type of account shine for savers. That's especially true for those who can take advantage of a long time horizon, says Vargas. "Do you pay taxes now or later? With an HSA the answer is (can become) never," said Vargas.
HSAs' Triple-Tax Edge
The upside to the tax-advantaged HSA is that it produces higher after-tax returns than other account types, the Vanguard study noted. In fact, the favored tax status of HSAs enabled this account type to post a much higher return on a fixed investment with a holding period of 25 years, says Vanguard.
For example, $1 invested in an HSA was valued at $4.29 after-tax a quarter of century later, vs. just $2.98 for a traditional or Roth IRA, and $2.49 for a taxable account. The bigger return of the HSA is because the entire $1 is shielded from taxes for the life of the asset.
What's more, no matter if you save or use your HSA to fund medical expenses, you will pay less in taxes each year than you would if you didn't open and fund an HSA, the Vanguard study found.
HSAs Sport Unique Flexibility
It's true only withdrawals for qualified medical expenses can be withdrawn tax- and penalty-free. But that doesn't mean dollars you have growing in an HSA can't be used for other purposes.
Here's how flexible HSA withdrawal rules on qualified expenses can enable you to pay for many types of nonmedical expenses. This strategy assumes that you are saving every dollar you contribute in your HSA, and paying for approved medical expenses out of pocket.
Vanguard uses the example of a family that lays out $4,000 today for a child's braces. If you save the receipt — and that is the critical piece you must get right — you can reimburse yourself for that big expense later by withdrawing that identical amount ($4,000) tax-free from your HSA. That money can then be used for other purposes, such as retirement costs or college tuition, according to Vanguard.
Keep Track Of Your HSA
But good record-keeping is crucial to executing this game plan.
"The trick here is to retain the receipt, or the documentation, for those qualified medical expenses," said Vargas. "Where the advantage comes in is there is no statute of limitations on when you can reimburse yourself for those costs. You can reimburse yourself at any point in the future."
For this strategy to work best, of course, the longer you wait to reimburse yourself out of the HSA the better. The reason? Your money will have more time to grow tax-free in your account. "The HSA could accumulate substantial assets," said Vargas. Similarly, to maximize this reimbursement strategy also means you must save your HSA contributions and pay for medical expenses out of pocket.
The key step to putting an HSA savings strategy into practice is to make sure you open an HSA if you're eligible to do so. Then make sure you max out your contributions each year if your budget allows and invest your savings in assets with more growth potential than cash, such as stocks and bonds, Vanguard says.
Bottom-line: "There are compelling reasons to include an HSA in your retirement-savings plan," said Vargas.
