ESI Money is now offering a free ebook titled Three Steps to Financial Independence. Get your copy here.
The following is a guest post from Mr. ToughMoneyLove from Tough Money Love.
Health Savings Accounts (HSA for short) have become all the rage in recent years, particularly for small businesses like mine that struggle to balance benefit cost control with taking care of our employees. So, several years ago we introduced a high deductible insurance plan with an HSA. We fund most of the deductible for our employees with quarterly contributions. We also allow our employees to make additional contributions on their own, subject to the maximum contribution allowed by IRS regulations. The maximum contribution (the aggregate of employer and employee contributions) allowed in 2008 is $5650 for a family plan like mine. I can contribute an additional $900 this year because I am over 55. All of these contributions are "above the line" meaning that they are not included in your taxable income on your Form 1040.
For the first two years, I followed conventional practice and used HSA funds to pay for all of our medical expenses, including approved expenses that were not covered by our insurance plan (over the counter medications and such). However, at the end of 2007 I began to think about the conventional wisdom and studied various government rules and publications about HSA contributions. It was then that I realized that I could likely obtain a greater long term financial benefit from my HSA funds by NOT spending them now. Instead, I could let them accumulate in the account and withdraw those funds when I retire later (including any investment earnings and appreciation), absolutely tax free. In other words, I was going to use my HSA account as a "super Roth" account.
Why do I refer to my HSA as a "super Roth" account? We all know that funds that are deposited in a Roth IRA (or that are contributed to the Roth component of a 410k plan) can be withdrawn in retirement tax free, including accumulated earnings and appreciation on the contributions. The only drawback is that the contributions are "below the line" i.e., they are included in your taxable income. Nevertheless, that is still a good investment strategy for many because tax rates are expected to go way up for future generations. (If you don't believe this, do some more research!) Turning to the HSA, we now see that you can get the tax-free benefit both going in and coming out. You don't pay any tax at all on those HSA funds, as long as they are used for qualified medical expenses. Thus, it is a "super" Roth. For me, its really a double super-Roth because our income is over the limit allowed for contributing to a Roth IRA. For the HSA "super" Roth, there are no such income limits.
Right now readers are thinking "wait a minute - how are you going to get all of that money out of the HSA without paying taxes unless your future medical bills are astronomical." That brings me to the second part of the strategy. First, we are saving all of our receipts for every qualified medical expense we incur and putting them in a file. There are lots of them, believe me: aspirin, bandages, ointments, eyeglasses, dental bills, etc., along with all of the typical physician bills and prescriptions. We are going to save these until we retire and need some tax free income. I checked IRS regs and publications and there is no rule against withdrawing HSA funds accumulated (and grown) over many years and applying them to unreimbursed qualified medical expenses that you incurred in past years, as long as they were incurred after you set up the HSA. So, if I want $5000 in tax free income in 2015, I can pull out $5000 from my HSA and match those funds up with $5000 in receipts from my file. Because we already paid those old bills, I can use the $5000 withdrawal in 2015 for anything I want, tax free.
Now readers are thinking "what's the big deal you - you are just withdrawing funds later that you could have withdrawn earlier, also tax free." My response is not to forget about the accumulated investment earnings. If the market has been decent, I will have a nice pool of money to use for other medical expenses. Thus, the second part of this strategy is that when I am 65, I will have to pay Medicare premiums. These premiums are increasing faster than the rate of inflation. Even though HSA funds cannot be used to pay conventional health insurance premiums now (or for Medigap coverage when I retire), the IRS will allow me to use HSA funds for Medicare premiums and for some types of long-term care insurance. I will also have other health care expenses that Medicare does not cover. That's where the accumulated investment earnings (I hope!) will go. Again, its all tax free.
Now skeptics are saying "what if Congress enacts a national health plan for all Americans. You won't have any future premiums or medical expenses." My answer is that (a) don't count on 100% reimbursement with any future plan and (b) I still have my old medical receipts file. Plus, even if I want to use HSA funds for non-medical expenses, I can do so without penalty (paying ordinary tax rates) after I turn 65.
Of course, before you implement the HSA "super" Roth strategy, you want to make sure that you have access to suitable investment vehicles for your contributions. Our HSA provider is Wells Fargo. It offers a handful of decent (not great) mutual funds for HSA deposits. I have selected a balanced fund that I hope will show 6%-8% annual tax free growth over the next 10 years. If so, our HSA funds will give us additional flexibility in managing the tax burden of withdrawing and spending taxable and tax free retirement assets in the future.
In summary, if you can afford to delay using your HSA funds and instead leave them invested, your payoff in retirement will be substantial. You will receive tax free benefits that surpass those of even a conventional Roth IRA or Roth 401k. The "super" Roth!