Don’t Sacrifice HSA Tax Benefits in Retirement

An elderly couple sitting on the beach looking out into the ocean

“And what happens if you suffer the misfortune of living longer than the average person after turning age 65 . . . ? Why not preserve those Health Savings Account balances for qualified expenses and make withdrawals for non-qualified expenses from the account only after you exhaust your traditional IRA balances? Think of it as long-life tax-saving insurance.”

William G. (Bill) Stuart

Director of Strategy and Compliance

February 18, 2021

You hear this message about Health Savings Accounts all the time in media ranging from open-enrollment presentations to articles in the popular press: “And once you turn age 65, the penalty goes away, and distributions are treated the same as withdrawals from an IRA (Individual Retirement Arrangement).”

Technically, this statement is correct. But it doesn’t reflect the financial benefit that you’ll forego if you withdraw funds from a Health Savings Account for non-qualified expenses. Let’s examine this issue in more detail.

Distribution Rules

Beginning in the year that you turn 59½, you can distribute funds from an IRA for any purpose without paying an early-withdrawal penalty. Your distribution is included in your taxable income. If you’re in the 12% federal marginal tax bracket and pay a 5% state income tax, you must withdraw $120.48 from your traditional IRA to spend $100 and pay the $20.48 in taxes. That may not seem like much of a penalty. But withdraw $1,000 per month ($12,000 annually) to supplement your Social Security benefit in retirement and you must withdraw $14,457 to spend $12,000 and pay taxes of $2,458.

Beginning in the year that you turn age 65, the 20% additional tax for Health Savings Account withdrawals for non-qualified expenses is waived. If you spend a distribution on anything other than a qualified expense, the withdrawal is included in your taxable income. The tax implications and required withdrawal mirror the figures above.

So, where is the financial loss?

The Lost Financial Opportunity

Imagine you’re enrolled on Medicare and have an inpatient stay. You pay a deductible of $1,484, which we’ll round up to $1,500 to make the math simple. You can withdraw $1,500 from your Health Savings Account and incur no tax liability or distribute $1,807 from your traditional IRA to pay the $1,500 bill and $307 tax liability.

Clearly, withdrawing funds from the Health Savings Account is better for you financially. Your balances go farther when you incur no tax liability.

But what if you’d spent the last of your Health Savings Account funds earlier in the year on a quick vacation? That distribution is included in your taxable income – just like all traditional IRA withdrawals. You’d have taken out $1,807 to pay the $1,500 vacation tab and the $307 to pay taxes on a distribution for a non-qualified expense. Then, when your Medicare deductible bill is due, you need to withdraw $1,807 from your traditional IRA to pay the $1,500 charge and the $307 in taxes.

That’s two $1,500 expenses. You spend only $3,307 ($1,500 from the Health Savings Account and $1,807 from the traditional IRA) if you pay the qualified expense from the Health Savings Account. If you pay for the $1,500 vacation with a taxable Health Savings Account distribution, you must withdraw $1,807 of taxable funds from your traditional IRA to pay the hospital bill. Total withdrawals from the two accounts: $3,614.

Medical Costs in Retirement

The most popular projection of the cost of medical coverage and care in retirement is published annually by Fidelity®. The 2020 figure for a couple retiring at age 65 in 2020 was $295,000. The Employee Benefits Research Institute (EBRI) calculates ranges based on confidence levels. If you want to have a 90% chance of covering medical expenses in retirement, a couple retiring at age 65 in 2020 needed between $276,000 (low prescription expenses) and $335,000 (high prescription expenses).

Regardless of which methodology you accept, the message is clear: Expect to pay $300,000 if you and your spouse live an average lifespan after turning age 65.

The point? If your Health Savings Account balance exceeds $300,000, you may decide to make some withdrawals for non-qualified expenses. You sacrifice tax benefits unless you’ve accumulated a sufficient balance to pay $300,000 or so in qualified expenses tax-free and additional funds to withdraw for non-qualified expenses that are included in taxable income, as traditional IRA distributions are.

But few people have $300,000 balances in their Health Savings Accounts. And what happens if you suffer the misfortune of living longer than the average person after turning age 65 (the 2018 figures are an additional 20.7 more years for women and 18 more years for men)? Why not preserve those Health Savings Account balances for qualified expenses and make withdrawals for non-qualified expenses from the account only after you exhaust your traditional IRA balances? Think of it as long-life tax-saving insurance.

Financial Benefits beyond Tax-free Distributions

Health Savings Accounts offer other financial benefits to seniors as well.

RMDs: Beginning in the year that you turn age 72, you must begin to make Required Minimum Distributions from a traditional IRA. The IRS sets this figure annually, based on your account balance and projected longevity. For example, if you’re age 75 in 2021 and have a $500,000 traditional IRA balance, you must withdraw $21,834. You might need at least that much to live, in which case it’s not a burden. But you have to take that taxable distribution even if you sold an asset (like a home or business) and are flush with cash, or the value of your investment dropped and you plan to withdraw $21,834 from a cash-reserve account so that your investments can rebound. Your needs don’t matter – the distributions are, as their name implies, required. In our example of a 17% tax rate, this distribution will generate a tax bill of $3,712.

Health Savings Accounts aren’t subject to RMDs. You‘re never required to withdraw any amount from your account.

Medicare Part B Premiums: The standard Medicare Part B premium is $148.50 monthly. This figure represents about 25% of average monthly claims costs. The federal treasury subsidizes the remaining 75%. But enrollees with higher incomes see these subsidies reduced, thus increasing their premiums, through a provision in the law called IRMAA.

Most Medicare recipients don’t reach these limits (the standard $148.50 premium applies incomes up to $88,000 for individuals and $176,000 for couples). But if you’re on the cusp of this threshold, you benefit financially by withdrawing balances for qualified expenses from a Health Savings Account (not included in taxable income) rather than a traditional IRA. Moving to the next level of Part B premiums costs an additional $712.80 in 2021 – double that for couples.

Provisional Income: The percentage of your Social Security benefit that’s included in taxable income is 0%, 50%, or 85%, depending on what’s called your provisional income. Provisional income includes gross income (IRA distributions, pensions, and annuities), interest (including tax-free interest), and half your Social Security benefit. The relevant income levels are $34,000 (single) and $44,000 (married). Above these figures (which aren’t indexed for inflation) the federal government taxes 85% of your Social Security benefit. The average Social Security monthly benefit in 2021 is $1,543, or $18,516 annually. If you’re at the 17% tax rate we used above, the difference is having $9,258 (half of $18,516) taxed at 17%, or $1,574 in taxes, or having $15,518 (85% of $18,516), or $2,638 in taxes. That’s an additional $1,064 in taxes.

Your Health Savings Account distributions for qualified expenses aren’t included in this income figure.

If you’re close to those thresholds, remember that a Health Savings Account withdrawal for a non-qualified expense may result in taxation of 85%, rather than 50%, of your Social Security benefit.

The Last Word

Workers spend time accumulating retirement savings. But too often retirees don’t have a plan for maximizing the spending power of their retirement balances. That’s a discussion to have with a financial or retirement advisor.

But this rule of thumb should help: Always limit your distributions from your Health Savings Account to qualified expenses. (Possible exception: you’ve been given only weeks or months to live and want to spend as much as you can while you’re still alive.) No matter your Health Savings Account balance, you’re very unlikely to outlive it. You benefit in many ways financially by limiting distributions to qualified expenses – even if, on the surface, the immediate income-tax treatment of distributions for non-qualified expenses and IRA withdrawals is the same.

What We’re Reading

How did members of Congress do addressing price transparency for medical services in the pandemic bill it passed in late 2020? One respected voice in healthcare policy says the legislation is a promising start, but the rules need to be strengthened.

Do Americans understand how their medical coverage works? No – according to the results of this survey of 2,000 adults. They averaged a “D” on the 15-question exam.

Only about one in 20 Health Savings Account owners invests a portion of their balances in mutual funds and other equities for long-term growth. Why is this percentage so low? Learn more about the causes and possible solutions here.

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