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How to use a health savings account to build retirement wealth

April 25, 2016

By Richard Barrington | MoneyRates.com Senior Financial Analyst, CFA

health savings account and retirement

Fighting the rising cost of health care is one of the great financial challenges of the modern era. Health savings accounts (HSAs) can help you pay that cost, but more than that, they can even help you accumulate more money for retirement. While this resource is often underutilized, it's not too late to get started.

What is a health savings account?

An health savings account is a tax free savings account designed to be used in conjunction with a high deductible health plan (HDHP). As the name suggests, an HDHP has a higher deductible than most health care plans (2016 deductibles must be at least $1,300 for individual coverage, $2,600 for family plans). The trade-off in having an HDHP is that premiums are typically cheaper, but you incur more out-of-pocket expenses.

Why use a health savings account

An HSA can help you pay for out-of-pocket medical expenses. For 2016, you can contribute as much as $3,350 to an individual HSA, and $6,650 for a family plan. Those contributions are tax-deductible, and earnings on them are tax-free. There is also no tax on distributions from an HSA as long as those distributions are used to pay qualified medical expenses.

The chief benefit of using the combination of an HDHP and and HSA is that even with higher out-of-pocket costs, HDHPs typically result in lower health care expenses because they avoid subjecting fairly routine expenses to the insurance process. In turn, an HSA gives you a tax-advantaged way of accumulating savings to cover those out-of-pocket costs when they occur. Significantly, unused HSA savings can be carried forward to pay for health care costs in future years, and can be taken with you when you move from one employer to another.

IRS rules concerning HDHPs and HSAs are complex, so you should check the details before participating. Not only can participating in an HDHP reduce your near-term health care expenses, but using an HSA can also be a means of increasing your long-term retirement savings.

4 health savings account benefits for retirement savings

You have to participate in an HDHP to be eligible for an HSA. Due to that requirement, people often use an HSA to fund their out-of-pocket health care expenses, topping off the HSA balance from year-to-year as necessary. However, because HSA balances can be carried forward for use against future health care expenses, they can also be a vehicle for adding to your tax-advantaged retirement savings.

Here are four key aspects of HSA benefits for retirement:

1. Prepare for growing health care expenses

Money you accumulate in an HSA has to be used, sooner or later, for health care expenses. Unlike 401(k) or individual retirement account (IRA) savings, it cannot be used for routine retirement spending. However, health care expenses are greatest in a person's later years, so there should be plenty of opportunity to use HSA balances to cover these expenses, saving other retirement savings for general use.

2. Use HSAs for wealth accumulation

Qualified retirement plans like 401(k)s can be used for retirement wealth accumulation, but annual contributions are capped, as are contributions to an HSA. Using an HSA in addition to a retirement plan thus increases the overall deductible amount you can put into long-term retirement savings.

3. Work savings in tandem with 401(k) plans

HSAs and 401(k) plans have different advantages. 401(k) contributions are often eligible for some amount of employer matching, which effectively gives you an instant return on your investment. However, while 401(k) money is taxable when distributed from the plan, HSA money is not as long as it is used for qualified medical expenses.

So, a good way to use HSAs and 401(k)s in tandem is to first contribute enough to the 401(k) plan to maximize the employer match; then contribute to the HSA to maximize the tax benefit. Finally, if there is money available after reaching the HSA limit, contribute more to the 401(k) up to the applicable limit.

4. Think of HSAs for future investments

Using HSAs for long-term savings means investing them accordingly. One approach would be to keep enough of your balance liquid to cover out-of-pocket health care expenses, and then invest the remainder in long-term assets for growth.

Tax-advantaged vehicles, including HSAs along with IRAs, 401(k) plans and other qualified retirement plans, perform a dual role. By helping people avoid or defer taxes on savings, they enable those savings to grow more quickly.

In addition, the opportunity to gain a tax advantage increases the incentive to save. That incentive is limited by the contribution ceilings on these vehicles. However, by adding HSAs to your retirement savings mix, you can increase your incentive to save, and thus increase your wealth in the long run.

Comment: Do you have a health savings account? 

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