I am a dedicated saver. Yet I did something this month I almost never do. I took money out of a retirement account and spent it instead of letting it continue to grow tax-free. Why?
The account in question is an HSA (Health Savings Account), and I want to share with you a slam-dunk way to save your heirs thousands (or even tens of thousands!) in potential HSA taxes that very few people know about.
This applies to you if:
- you have a HSA (Health Savings Account), especially one with a larger balance
- you are age 65 or over
- you are unmarried or have a non-spouse beneficiary on the account
If this describes your situation, read on for huge tax savings.
So what’s an HSA?
So here’s the deal. HSAs (Health Savings Accounts) are great ways to save for current and future health costs on a tax-advantaged basis during your working years. If you are covered by a high-deductible health plan, you can contribute to your own HSA, deduct the contributions, watch the money grow tax-free over time, then withdraw the funds tax-free to cover medical expenses. That’s why financial planners love HSAs and call them ‘triple tax-free.’
But what happens to your HSA when you start Medicare?
You keep your HSA ‘as is’ when you start Medicare coverage at 65. Although you lose the ability to make new contributions to the HSA, you are free to use whatever is already in your HSA to cover unreimbursed health expenses and may withdraw those funds tax-free and penalty-free. Note, however, that If you withdraw funds to cover something other than qualified medical expenses, the withdrawal is still penalty-free but you will pay income tax as applicable.
So where’s the problem?
A potential problem arises if you do not spend down the HSA during your lifetime and leave the remaining funds to someone other than a spouse at your death. Spouses inherit your HSA account free of tax. But non-spouses (like children) face different and harsher tax treatment, much worse than what they would face if inheriting a typical retirement account.
Let’s say your HSA account still has a balance of $100,000 when you die. You leave the account to your daughter Susan. Susan will have to withdraw the full account balance immediately. As a non-spouse, she’ll be taxed with $100,000 of income resulting from the HSA withdrawal, subjecting her to a potential income tax bill totaling tens of thousands of dollars. A good chunk of your savings will end up in the hands of the IRS.
That’s bad news! So here’s what you can do instead to avoid that big tax bill
There’s a really simple solution to this conundrum. If you have an HSA account, are 65+, and are single (or married with a non-spouse beneficiary), just starting drawing down your HSA balance by making withdrawals each year to reimburse yourself for qualified medical expenses. In other words, start using up your HSA funds right away. Don’t save it to leave to your heirs. After all, you don’t pay any tax or penalty for these withdrawals, but your heirs will.
It shouldn’t be hard to come up with enough expenses to reimburse. Fidelity Investments estimates that a 65-year-old retiring today could spend an average of $172,500 on health care in retirement. Medicare premiums alone can exceed $700 per month thanks to IRMAA and the extra premiums assessed on higher income people.
Tax-Saving Tip: You can withdraw money from your HSA tax-free and penalty-free for these expenses
What are examples of qualified medical expenses that you can reimburse yourself for from your HSA without paying any tax or penalty?
Medicare Premiums: Parts B, C (Medicare Advantage), and D (Prescription Drug)
Dental Care: Cleanings, fillings, dentures, orthodontics
Vision Care: Eye exams, glasses, contact lenses
Prescriptions: Medications, over-the-counter items (with a doctor’s note)
Doctor Visits & Hospital: Copays, deductibles, coinsurance, diagnostic tests
Hearing Aids & Services
Long-Term Care: In-home care, nursing home costs (up to limits)
And don’t forget, you can also withdraw funds for non-medical expenses from your HSA in retirement without penalty, although normal income taxes will apply.
The Takeaway:
HSA accounts are a great way to save for medical expenses on a tax-advantaged basis. But if you are single, start drawing down HSA balances once you hit retirement. Don’t plan on leaving the account to non-spouse heirs, as hefty tax bills could apply.