Should an HSA Be Your Main or Sole Retirement Account? Definitely Not!

Yes, a Health Savings Account can play an important role in retirement in meeting expenses and minimizing taxes. But contributions to a Health Savings Account alone are unlikely to fund a comfortable retirement.

The Motley Fool, the popular personal-finance source of information, recently asked in an article whether you should make a Health Savings Account your main retirement savings account. A subhead labels this question "tricky." But it really isn't.

Funding Needs in Retirement

Let's start with the amount of money that you'll need in retirement. This is a very personal question. People's expected and realistic standards of living vary dramatically. Thus, it's impossible to determine how much money you will need to cover your lifestyle in retirement.

But we do know that the average couple retiring at age 65 in 2022 will incur more than $300,000 of expenses to cover Medicare premiums, Medicare cost-sharing, and medical, dental, and vision expenses not covered by Medicare. Fidelity says the figure is $315,000. The Employee Benefit Research Institute expresses its figures in confidence intervals and breaks them down by low- and high-prescription seniors. Their figures fall within 10% (plus or minus) of this figure.

If you opened a Health Savings Account when they were introduced in 2004 and made the maximum contribution each year during those 19 years, you would end 2022 with a balance of $354,000, assuming that your investments matched the S&P 500 return during each of those years. By the way, that figure includes an 18.35% drop in 2022, which knocked $70,000 off your balance at the end of 2021. This scenario is overly optimistic, as today only about 7% of all owners invest any of their balances.

You can argue that someone closer to age 65 would place a portion of the balance in a safer investment. OK, let's assume that at age 55 (2012), this account owner put the full balance into an annuity that credited 60% of the S&P 500 gain in a year of positive returns and 0% in years of negative returns. The balance at the end of 2022 would have been only $281,000. If this account owner spent $1,000 annually to reimburse current qualified expenses tax-free, the balance would drop to $238,000.

Even in the most optimistic scenario (maximum contribution, no withdrawals, investing the full balance and enjoying market returns) leaves an owner turning age 65 in 2022 with roughly enough to cover projected qualified medical expenses through the rest of her life. Thus, she must find other sources of income or assets to pay for taxes, shelter, food, clothing, transportation, entertainment, and other expenses.

Of course, an owner who opens a Health Savings Account at age 25 and thus has four decades or more to fund the account can build balances far exceeding projected retirement medical expenses. But it's difficult to determine how much more. After all, the $315,000 figure is for a 65-year-old couple retiring in 2022. The figure will be very different for my youngest child, who turns 65 four decades from now. At a 5% annual rise in expenses, the figure will be $2.112 million for his future wife and him in the year 2062. In a more optimistic scenario - let's say 4% annual growth in expenses - the projected figure is only $1.45 million. Will the market yield the returns necessary to keep up? More than a century of stock-market performance suggests that it will. But there are too many variables - including the end later this decade of funding Medicare inpatient services through the payroll tax alone - to project four decades into the future.

The Benefits of a Health Savings Account

The article rightly points out that Health Savings Accounts are the only vehicle through which Americans can save for future expenses with no tax liability on either the front end (contributions) or back end (distributions). Contributions to a tax-deferred retirement account aren't included in taxable income, but withdrawals - including both the funds contributed and the growth of the balance over time - are included in taxable income. Contributions to a Roth retirement account are post-tax, but in most cases distribution of deposits and account growth are tax-free. Health Savings Accounts offer the tax advantages of both forms of retirement account with withdrawals are for qualified expenses.

Tax Diversification

Retirement planners and financial advisors recommend that their clients diversity their investment portfolios. In this context, they mean that retirement savers should spread their savings across a range of asset classes - domestic and international equities, stocks or mutual funds of companies of different sizes, bonds, real estate, etc. - because these assets classes don't all mirror the overall performance of financial markets. In a typical decade, five or more classes will experience the greatest gains in any single year. Thus, diversification generally leads to returns that gyrate less than the performance of any individual class during a specific period.

But diversity extends beyond mere asset classes. The same logic - not being totally tied to one approach - leads to the concept of tax diversification as well. Many retirement savers have been instructed to save in tax-deferred accounts because they'll be in a lower tax bracket in retirement. That idea has been challenged recently with increasing federal spending and the loss of tax deductions (notably the home mortgage deduction when a primary residence is paid off) in retirement.

Further, the fact that tax-deferred withdrawals are taxed is only one disadvantage. Higher taxable income can increase monthly premiums for Medicare Part B (outpatient services, like day surgery, outpatient cancer treatment, doctor visits, lab work, and physical therapy) and Part D (prescription-drug coverage) and increase the percentage of Social Security benefits that are taxed.

Tax diversification simply means that retirement savers allocate their contributions across accounts with different tax treatment. We don't know the tax policies that a future Congress and president will enact. We don't know whether our marginal federal tax rate will be higher or lower in retirement. We don't know whether we'll move from New York or California (high state income taxes) to Florida or Texas (no state income taxes) in retirement, or whether we'll remain in - or return to, for family or medical-treatment reasons - a low-tax state).

Given that uncertainty, a logical strategy is to diversity tax risk by placing some retirement savings into accounts that offer tax benefits now (tax-deferred) and some whose tax benefits are realized in the future (Roth). Savers can enact this strategy by funding both a tax-deferred 401(k) plan or Individual Retirement Arrangement (IRA) and a Roth 401(k) plan or IRA. Or, if they've spent a lifetime funding a tax-deferred account only, they can convert a portion of their balances in tax-deferred balances into Roth accounts (paying the tax liability in the year of the conversion).

Note that Health Savings Accounts aren't included in either of these strategies. That's because Health Savings Accounts enjoy the preferable tax treatment on both contributions and distributions. Thus, owners don't have to choose on which end to pay taxes and diversity their retirement portfolio accordingly. Health Savings Accounts are the tax-perfect way to save for qualified medical expenses later in life.

The Bottom Line

Yes, it makes financial sense for Health Savings Account owners to contribute as much as they can - up to the annual limits - into these tax-perfect accounts. They offer tax advantages that other retirement accounts can't match. Health Savings Account owners don't have to choose whether to be taxed on contributions or distributions because they face no tax liability on either end if withdrawals are for qualified expenses.

But don't rely on Health Savings Accounts alone to fund your retirement. The annual contribution limits - even if you incur few qualified expenses along the way or your consciously choose to pay those expenses with current after-tax funds to preserve your Health Savings Account balances - and your Social Security or pension benefits are unlikely to cover all your living expenses in retirement. Yes, assign your Health Savings Account a prominent position in funding your retirement. But focus first on how much you'll need for retirement so that you can fund other accounts as well to meet those needs.

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