HSAs Are an Ally in Paying Retirement Medical Expenses

Projected retiree medical costs didn't increase this year. That's the good news. The sobering statistic is the projected total. But a Health Savings Account can lower the net effect of these expenses.

Note: HSA Wednesday Wisdom and HSA Monday Mythbuster won't be published next week. Enjoy Independence Day!

How much of a bite will medical expenses take out of your budget in retirement? It depends on how long you live, your health, how you shop for care, your coverage, and where you live.

But Fidelity's projection has become the most oft-quoted figure in retirement planning. Fidelity projected that a couple retiring at age 65 in 2022 would spend $315,000 on medical, dental, vision, and hearing premiums and out-of-pocket expenses during an average remaining lifespan. In 2023, Fidelity acknowledged the growing number of one-person retiree households and redefined the projection to reflect a figure of $157,500 per individual, or $315,000 for a couple.

The good news is that the figure is the same as 2022, primarily because Fidelity projects lower prescription-drug costs as reform to the design of Medicare Part D takes effect beginning in 2025. The bad news is that few retirees have thought about, never mind planned for, out-of-pocket medical expenses in retirement.

If you think Fidelity's projection is an outlier, think again. Other organizations crunch the numbers and apply different methodologies, such as different projections for healthy and unhealthy seniors or publishing ranges based on confidence intervals (e.g., a person who has saved $150,000 for retirement medical expenses has a 90% chance of not running out of money). No matter how the projections are calculated, they end up around $150,000 or more per senior or more than $300,000 for a couple.

It's worth reminding readers about four advantages that Health Savings Accounts enjoy over tax-deferred and Roth retirement accounts. As a refresher, contributions to tax-deferred retirement accounts aren't included in taxable income, but withdrawals are always taxable. Roth accounts are funded with post-tax dollars, but distributions are generally tax-free. Neither contributions to nor distributions from a Health Savings Account are included in taxable income.

There are, however, four additional distinct advantages to saving for retirement medical expenses in a Health Savings Account rather than a traditional retirement account. That's not to say it's an either/or proposition. Rather, it's important that people who are eligible to open and fund a Health Savings Account consider the benefits of placing a portion of their retirement savings in these accounts rather than limiting contributions to traditional retirement accounts.

ONE: Payroll Taxes

Not above the discussion about the income-tax treatment of contributions to qualified retirement plans and Health Savings Accounts. Deposits to both accounts are federal- and state-income-tax-free (except that California and New jersey don't allow a deduction for Health Savings Account contributions).

The key word in this discussion is income tax. Federal payroll (FICA) taxes are applied to contributions to a tax-deferred retirement plan. That's a 7.65% levy paid by employees directly (with an equal amount paid by the employer) on every dollar of income up to $160,200. Above that income figure, the levy is 1.45% each for employees and employers.

TWO: IRMAA

Few prospective or actual Medicare enrollees understand the concept of the Income-Related Monthly Adjustment Amount calculation. In brief, this year's Medicare Part B standard premium is $164.90. That figure represents 25% of the average claims costs for outpatient care covered by Part B. The balance is paid from general revenues (in other words, from the same till that also pays for Medicaid, federal premium subsidies, education, roads, the military, student loans, national parks, and thousands of other federal programs).

That 75% premium subsidy is reduced at higher income levels, which hits working seniors, wealthy retirees, and older Americans who have a sudden spike in income (due to the sale of a primary residence or business). For example, a couple with $250,000 in taxable income this year will see their Part B premium double in 2025 (there's a two-year lag in applying IRMAA). That's almost $2,000 in IRMAA assessments each for that couple.

IRMAA also applies to Part D prescription-drug coverage, though the numbers aren't as dramatic. But the same couple would each pay a $31 surcharge above their Part D plan's standard premium per month (or an additional $372 each annually).

Withdrawals from a Health Savings Account are reimbursements rather than income. They don't increase taxable income.

THREE: Provisional Income

Most retirees pay federal income taxes on a portion of their Social Security benefits. Either 50% or 85% of their benefit is included in taxable income, depending on income. For example, a couple who each receive the average monthly Social Security benefit of $1,827 (about $44,000 annually) will, if they have some other income from a pension or a tax-deferred retirement account, see 85% (versus 50% with a lower income) of that benefit included in taxable income. That 35% difference applied to $44,000 is another $15,400 in taxable income. At a 20% combined federal and state income tax rate, that's another $3,080 in taxes due.

Health Savings Account withdrawals aren't included in taxable income. Most people who accumulate balances in their accounts to reimburse retiree medical expenses are likely to exceed the $3,4000 (single filer) or $44,000 (joint filer) income at which the 85% level applies. But in a case in which a $750 medical bill is due at the end of the year for a couple with income just under $44,000, the source of funds - tax-deferred retirement account or Health Savings Account - could swing their tax liability by more than $4,000 as illustrated in the paragraph above.

FOUR: Required Minimum Distributions

Retirement savers defer income taxes for decades on contributions and balance growth. At some point, the federal government wants to begin applying income taxes. Beginning in the year that you turn age 73, you're required to make minimum distributions from your tax-deferred accounts. You must take RMDs whether you need the money, want to retain your balance to grow after a bad year (or more of returns, or are still working and the extra income would place you in a higher tax bracket.

Example: Let's assume President Biden has $800,000 in a tax-deferred 401(k) plan or Individual Retirement Arrangement and earns a 6% annual return. Based on that information and his date of birth, in 2023 he would have to withdraw at least $41,237 to satisfy his RMD.

Health Savings Account balances aren't subject to RMDs. Account owners are never required to withdraw funds based on a government formula.

Following the $100 Trail

Let's imagine you make a one-time sacrifice of $200 in current consumption to save for retirement. You split the funds equally between your tax-deferred retirement plan and a Health Savings Account. Your total contributions are $92.65 to the retirement plan and $100 to the Health Savings Account. Then, each account grows at 6% annually. Here are the balances you'd accumulate in, respectively, the Health Savings Account and tax-deferred retirement plan:

• After 20 years: $303 and $279 (difference of $24)
• After 30 years: $542 and $500 (difference of $42)
• After 40 years: $970 and $896 (difference of $74)

The differences aren't huge. They do, however, increase over time as the one-time payroll-tax savings multiply. The gap is also larger with higher rates of return, for example, to $514 and $475 (difference of $39) after 20 years with a 9% rate of return.

That's the accumulation phase. During the distribution phase, let's assume that you face a $300 medical bill in, say, year 34. You can withdraw $300 from either account to pay the provider in full. That distribution is tax-free from your Health Savings Account. But the same $300 withdrawal from your tax-deferred retirement account leaves you with a tax liability of $75 if your combined federal and state income tax rate is 20% in retirement. Put another way, you deplete your retirement assets by $300 when you pay the bill from your Health Savings Account, but by $375 if you pay the same bill from your tax-deferred retirement account.

That $75 difference obviously isn't huge. That's just one bill, though. Consider an inpatient visit with a $3,000 deductible in the future. Now the difference is $750 for that one bill. And multiply that scenario by two decades of retirement. By diverting a portion of retirement savings to a Health Savings Account during the accumulation phase, you can increase your spendable income by tens of thousands of dollars in retirement.

The Bottom Line

Health Savings Accounts shouldn't compete with traditional retirement accounts as your source of saving for your post-working years. But it's important to view your Health Savings Account not only as a tax-advantaged source of funds to reimburse current qualified expenses, but also as an opportunity to extend those tax advantages to future qualified medical, dental, vision, hearing, and other expenses. Health Savings Accounts offer four distinct benefits that traditional retirement savings vehicles don't.

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The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.