September 25, 2017

When Should You Stop Funding Your HSA?

When Should You Stop Funding Your HSA?

A Health Savings Account (HSA) is a rare type of account where you can get a tax deduction when you put the money in and then pay no tax when you take the money out for qualified medical expenses.

In 2015, individuals with high deductible health plans can contribute $3,350 and families can contribute $6,650 per year. Those 55 or older can contribute an additional $1,000.

High income earners who are not allowed to contribute to their Roth IRA or deduct contributions traditional IRAs are still allowed to deduct contributions to HSAs.

Before age 65, any money you take out of your HSA that is not for qualified medical expenses is subject to a 20% penalty in addition to income tax.

At or after age 65, you are allowed to take money out of your HSA for any reason without paying a penalty.

Withdrawals that are for qualified medical expenses are not subjected to income tax.

Withdrawals for any other reason are subject to income tax. In this regard, at its worst, your HSA acts like a traditional IRA, receiving an income tax deduction on the way in and being subject to income tax on the way out.

That being said, HSAs have several advantages over traditional IRAs.

HSAs are not subject to required minimum distributions.

HSAs can be used in retirement to pay for qualified medical expenses with no tax. Those expenses include Medicare Part B premiums, dental care, vision, and co-payments.

HSAs can help you self-insure against the need for long term care.

Currently here in Charlottesville, Virginia, nursing home care costs are about $75,000 per year. Other types of care are less expensive.

Annual assisted living costs about $56,000 per year and adult day care costs about $21,000 per year. It is typical to have six months of nursing care at the end of your life. These costs can be under $40,000.

Longer need of nursing care is possible, but long term care insurance is a very expensive option. If you have $300,000 saved, this provides four years of nursing care if needed and is probably good self-insurance against potential long term care needs. .

One easy way to cover possible long term care insurance needs is to fully fund your HSA account every year. Leave one year’s worth of maximum deductible in cash and invest the extra HSA savings. At an 8% return, you will have saved over $300,000 in less than 20 years. This savings might be able to take the place of long term care insurance.

And, if you don’t need long term care insurance, the money can always be withdrawn to pay other expenses after age 65 so long as you pay tax like you would on a traditional IRA.

In short, there are few reasons not to continue funding your HSA to the maximum amount.

Upon your death, your spouse can inherit the HSA tax free as an HSA. Your HSA can also pay for qualified medical expenses incurred on your behalf up to a year after your death, but these do not include funeral expenses.

When an HSA is left to a non-spouse however, the account stops being an HSA. The value of the account becomes taxable to the beneficiary. If the beneficiary is your estate, the value is included in your final income tax return. If the beneficiary is an individual, they must include the value on their income tax return.

Unlike a traditional IRA, which can be taken out gradually over a number of years, the entire value of an HSA will be taxed for a non-spouse beneficiary in the year it is received.

This is the main disadvantage of an HSA over a traditional IRA. There are some ways to mitigate a large HSA being taxable all in a single year.

After your spouse, designating a beneficiary for your HSA who is subject to a low rate of income tax can have tax savings for your beneficiaries as a whole. If your income tax is lower, you can make your estate the beneficiary. If your children’s tax rate is lower, you can leave it to them directly. Or you can leave your HSA to a charity and prevent it from being taxed entirely.

In any case, funding your HSA until you have at least $300,000 helps self-insure against long term care. After $300,000, you can continue to fund your HSA as though it were your traditional IRA.

Photo used here under Flickr Creative Commons.

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About David John Marotta

David John Marotta+ is the Founder and President of Marotta Wealth Management, Inc. He played for the State Department chess team at age 11, graduated from Stanford, taught Computer and Information Science, and still loves math and strategy games. Favorite number: e (2.7182818...)

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