The IRS has a secret.
There is a retirement account that is even more tax efficient than an IRA.
What?! Why don’t I know about it?
Well, that’s the thing. You probably already do. This account is often overlooked because it is not advertised as actually being a retirement account. The IRS says it is meant to be used for something else entirely: medical expenses.
The Health Savings Account (HSA)
The HSA is primarily meant to be used to supplement medical costs for people in a high deductible health plan (HDHP). You specify how much money you want to contribute annually, and your taxable income is reduced by that amount, just like contributions to a 401k. Not a bad deal, right?
It gets even better. Unlike its cousin, the Flexible Spending Account (FSA), the HSA does not have a “use it or lose it” rule, so each year’s contributions carry over to the next. And, it stays with you even if you leave your employer. The money you or your employer put in is yours to keep.
And it doesn’t stop there! There are even options for investing. That’s right. Compound interest: a FIRE-seekers best friend. Like other tax-advantaged accounts, all investment gains in an HSA are not taxed, so the money compounds faster than it would in a taxable brokerage account.
Tax deductions and tax free gains – Sounds pretty similar to an IRA or a 401k, doesn’t it?
So why isn’t the HSA a celebrated part of the retirement portfolio?
It’s named a Health Saving Account for a reason. Until you reach age 65, all withdrawals from the HSA have to be used to pay for medical expenses.
And that’s what most people use it for: doctor visit copays, insurance deductibles, and eye exams. That basically makes it an FSA. You contribute all you expect to spend for that year, and then you withdraw it when you need it. Boring.
Is there a better way to use the money in an HSA?
Yes, there is!
The medical IRA
An HSA can be treated like a “medical IRA.” The thinking is that everyone will have higher medical expenses later in life, so it is best to save and invest for it now. Instead of using it to cover your current medical expenses while you have a reliable income, set aside some of your savings for future medical expenses when you are retired.
Fidelity reports that the average 65-year-old couple retiring in 2017 will need $275,000 just for medical expenses in retirement. THAT’S $137,500 PER PERSON JUST FOR MEDICAL EXPENSES. (This is clearly something that you should be planning for.)
If we take that $137,500 figure as gospel, how much would a 25-year-old need to contribute annually if they started their working career today and planned to work a typical period of 40 years? About $600 (assuming 7% real returns). Definitely doable.
However, as efficient as an HSA is, an early retiree will probably want to put in as much as possible to reduce income tax liability. The IRS (in its infinite wisdom) has allowed an individual to contribute up to $3,400 annually to an HSA, which if invested can get you to that $137,500 a LOT quicker: within 18 years.
Let’s say that the 25-year-old worker (Anna) has a change of heart and decides to retire early at age 45. Anna contributes the maximum (2017) annual contribution of $3,400 for her entire 20 year career, and then stops contributions. At that point in her life, Anna probably still would not have high medical expenses, so she doesn’t need to tap into the HSA yet. Instead, she leaves it alone and lets it continue growing.
As you can see, it is possible that the modest early retiree can accumulate more money in an HSA than one would need for medical expenses*.
This is definitely an efficient tool for building wealth, but what is the point if you can only use it for medical expenses that you don’t need? Why build up wealth if you can’t even use it?
There are actually techniques to access the money for non-medical expenses, which brings me to the main purpose of this post: How should an aspiring early retiree use an HSA to their advantage?
Maximize HSA contributions
Just like with a 401k or IRA, making the maximum contribution to your HSA ($3,400 for individual, $6,750 for family) is a great way to reduce your tax liability. Why? Because all contributions are tax deductible. Your taxable income is reduced by the amount you contribute, which is a great deal.
Invest in your HSA
Did you know that you could invest the money in your HSA? It’s okay if you didn’t. According to a recent survey, 49% of account holders were not aware that they could invest the money in their HSA, me included. I had my HSA for two years before I figured it out!
If you are already on the path to FI, you probably already appreciate the benefit of investing in low cost index funds. If not, take a look at the graph above. Odds are that your HSA provides you with access to investment options, but if you are limited to high fee funds, or none at all, I recommend discussing it with your employer’s HR department. Here is a screenshot of some of the mutual funds in my HSA.
You probably won’t be hurting for the money between now and retirement, so why not put that cash to work building up your net worth?
Use your HSA like a traditional IRA
After age 65, your HSA can be used to fund any expense, effectively making it a traditional IRA (tax-wise). Even then, medical expenses are still tax deductible.
I think this is one of the most important points to understand. You are not forever limited to only using your HSA for medical expenses. Even if you firmly believe that you will be healthy forever and that you will never need to make withdrawals from you HSA, the fact that you can make withdrawals for any expense after age 65 is a pretty good argument for maxing out your contributions now.
The Mad Fientist’s Approach: Save Your Receipts
One popular FIRE-themed technique for accessing HSA funds is to save receipts for every medical related expense incurred during your wealth accumulation years. During this time you are paying for every non-insurance covered expense out of pocket, instead of drawing from your HSA. When you are in early retirement, you can then reimburse yourself for those expenses retroactively and use that money for normal, non-medical expenses. The Mad Fientist talks more about this here.
The advantage to this is that your money stays in the HSA for a long period of time, thus maximizing the potential for capital gains, and it gives you a lot of flexibility for how you use the money in early retirement.
To me, this seems like nickel-and-diming your way to early retirement. I am not going to go to the trouble to save the receipt from every doctor visit just so I can withdraw that $100 in 20 years.
However, I can see some expenses being high enough to make it worthwhile. I would be more inclined to keep track of receipts for 20 years for expenses related to a broken leg than for a bottle of contact lens solution.
Before you can even consider using an HSA, you should first asses whether enrolling in a HDHP is the right decision for your situation. Different people have different medical needs and situations, so an HDHP might not be the best (or even cheapest) option available to you.
If you do decide to enroll in an HDHP, you can sign up for an HSA if you meet the following requirements (source):
- You are covered under a high deductible health plan (minimum deductible = $1,300).
- You have no other health coverage (your spouse can still have a non-HDHP as long as you aren’t covered by it).
- You aren’t enrolled in Medicare.
- You aren’t claimed as a dependent on someone else’s tax return.
If you do decide to go with an HDHP, I would certainly recommend also enrolling in an HSA. If your employer does not offer one (or the investment options are sub-par), you can set one up on your own. (Bogleheads has a brief overview of some of the low cost administrators available.) The only downside to this is that because you are making non-payroll contributions, you don’t get the FICA deductions, which allow you to reduce your taxable income by about 7%.
Do you have an HSA? How do you plan on using the funds? Let me know in the comments!
*This is for illustrative purposes only. Average medical expenses may be significantly higher in 40 years, so please consider your individual situation and do your own analysis.