Health savings accounts can be a significant vehicle to save for health care expenses in retirement, as HSAs have a triple tax advantage making them attractive ways to invest money toward filling in the gaps in Medicare coverage.

That was one of the main takeaways from a new white paper by the Employee Benefit Research Institute in collaboration with Inspira Financial.

HSAs not only cover health-care expenses not covered by an employee’s health insurance during their working years. They also can help retirees fill in the gaps in their Medicare coverage.

An individual could save more than $1 million in their HSA under the following assumptions:

  • Contributions are made for 40 years (assuming they start at age 25 and continue through age 64).
  • Maximum contributions are made each year, including catch-up contributions.
  • Distributions are never taken, regardless as to whether the individual uses any health care services.
  • The HSA earns a 7.5% rate of return.

EBRI research has found that the longer someone has owned their HSA, the larger their balance tends to be, in particular because the higher their contributions tend to be, the more likely they are to invest their HSA in assets other than cash. These strategies better position accountholders to withdraw larger sums when unexpected major health expenses occur and can leave accountholders more prepared to cover their sizeable health care expenses in retirement.

How much to save for health care in retirement?

How much money is needed to cover health care spending needs in retirement? To answer this question, EBRI built a multi-factor model allowing for inputs such as premiums, deductible spending, varying mortality assumptions, and an assumed rate of return on an individual’s retirement savings. EBRI found that a 65-year-old man enrolled in a Medigap plan will need to have saved $184,000 to have a high chance of having enough to cover premiums and prescription drug expenditures, and a woman will need to have saved $217,000. Couples will need to have saved $351,000.

When the Medicare Prescription Drug, Improvement, and Modernization Act passed in 2003, it created HSAs, which is the only tax-preferred account that gives individuals a triple tax advantage. Contributions are excludable from taxable income. Distributions for qualified medical expenses and certain premium payments are tax free. And interest and capital gains on account balances also build up tax free.

About one-third of employees are enrolled in a health plan with a deductible high enough to be an HSA-eligible health plan, EBRI said, but many of those employees do not have an HSA.

Employees need more knowledge about HSAs

Paul Fronstin, EBRI director of health benefits research and one of the authors of the report, said many employees don’t have a lot of knowledge about HSAs.

“They don't know they can invest in an HSA. They don't completely understand the tax treatment,” he said. “But we do find that over time, people start to get it and they start to behave differently. We found that the longer someone has an account, the more money they put into it and the more likely they are to invest. We are seeing this gradual shift.”

HSAs can be used to save for health care expenses in retirement in several ways, the EBRI report said.

First, most people contributing to an HSA will be able to build up a balance in their account because in any given year only 20% of the population use a significant amount of health care. To the degree they and/or their employer make contributions, HSA balances will accumulate and can be used for health care expenses in retirement when they are more likely to use health care services because older individuals typically use more health care services than younger individuals.

Second, in situations where individuals use health care services and can pay their expenses without tapping their HSA, they can take advantage of the tax free build up in the HSA.

In retirement, the HSA can be used to either pay for current expenses or reimburse themselves for past health care services paid for with after-tax dollars. HSAs can also be used to pay for expenses not typically covered by Medicare, such as long-term care insurance premiums and out-of-pocket long-term care expenses associated with receiving medical care.

The 80/20 rule in health care spending

One of the most crucial statistics in health care is the 80/20 rule, according to the EBRI report. Approximately 20% of the population accounts for 80% of total health care spending. This rule applies in the population with employment-based health benefits as well, where in 2021, 20% of the population accounted for 84% of total spending, and the minimum annual spend in this population was $6,000.

This population is comprised of high-cost claimants — enrollees who use a lot more health care than the average person — with the top five conditions in 2021 being related to nervous system disorders, heart disease, respiratory conditions, cancer, and musculoskeletal conditions. The flip side of the 80/20 rule is that 80% of the population accounts for only 20% of health care spending. In other words, most people do not use a lot of health care in any given year. Thus, most HSA owners will not need to take a distribution for health care expenses in any given year because they will not incur significant health care expenses. As a result, it can be assumed that most people will be able to build up a balance in their HSA each year.

Not every household with an HSA will be able to pay for medical expenditures out-of-pocket and refrain from taking distributions from their HSAs, the report said. However, even those taking distributions starting at age 45 could accumulate $665,000 depending on various assumptions. To the degree that individuals are concerned about overfunding their HSA, when they turn 65, they can take distributions for any purpose but will be required to pay income tax on the distribution. There is no penalty on distributions for nonqualified expenses once an individual is enrolled in Medicare.

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Consider this: just as people are enthusiastic about putting information on a landing page, they should also be enthusiastic about planning for their future caregiving needs. It's a crucial part of life's journey that deserves our attention and preparation.

Preparing for caregiving in advance, before the need arises, may not seem like the most exciting task. However, it is a crucial step that can significantly impact your future and the well-being of your loved ones.