The Next Marvelous Tax Trick
By now most of us are contributing to our employer-sponsored retirement plan, a 401(k), or an Individual Retirement Account. The popularity of recently promoted auto-enrollment and, in some cases, auto-escalation features have worked their magic and many of us have placed our tax-deferred retirement savings on auto-pilot.
These have much behavioral science merit and are a good thing. However, what they gain in locking in a habit they lose in individual engagement, and sometimes even understanding. As a result, you may have missed that there is an even better retirement savings tax trick available to you.
What could be better than these tax-deferred retirement savings instruments?
How about a tax-free retirement savings instrument?
That is what you get when you contribute to a health savings account (HSA) and use the funds for health related expenses. Since retirement is such a long ways off for most of us — even if it really isn’t from a wealth accumulation perspective — we tend to ignore the components of spend in our retirement years. As a result we don’t appreciate the tax optimization play available to High Deductible Health Plan participants.
What is this play?
Maximize your health savings account. Steer as much as you can within your retirements savings bucket into the brokerage features of your HSA. And then, to the extent possible, pay for your current medical expenses out of pocket, but hold onto the receipts.
Why would you do this?
Since you can withdraw funds from your health savings account at any time, the “hidden trick” is to maximize the growth of your HSA balances before you withdraw the funds. This way you are withdrawing a balance that has taken as much advantage of capital accumulation (i.e. market growth) as possible.
But where is the tax trick?
Keep your receipts.
$1,000 of receipts this year retained in your health savings account will grow to $4,000 of account balance in 20 years (or more). Then, withdraw the $1,000 to spend on whatever you want — it is your money, tax free — and leave the remaining $3,000 balance in the health savings account to continue its capital appreciation journey. Of course, like anyone in Vegas on a hot streak, you always have the option of “letting it ride.” The IRS doesn’t require mandatory withdrawals, unlike your IRA, and you do not face the dreaded “use-or-lose” loss penalty each year as you do with a FSA (Flexible Spending Account). Your health expenses represent an IOU that is always available to you, tax-free.
But why would I do this?
The simple example above is $1,000 of receipts. However, the average family is anticipated to spend $2,500 in out of pocket costs in 2015, according to a recent report from Aon Hewitt (here). Assuming average annual family out of pocket expenses remain constant for the next ten years — they won’t, of course — a $2,500 annual HSA accumulation grows to nearly $35K at the end of ten years (assuming 7% growth). That $35K more or less doubles every decade thereafter at a 7% rate (Rule of 72).
So the $25K cumulative of out of pocket expenses (i.e. your investment basis) grows tax free to a balance of ~$70K at year 20. And you can withdraw your funds tax-free at any time for health expenses, and your basis (the $25K cumulative health expenses) to spend on anything you want, as that amount simply represents a reimbursement you are owed. Of course, with the average retiree couple needing $220K to fund health care costs in retirement (see Fidelity release here), you may want that balance to ride a little longer.
Where is the catch?
Well, you should keep up with your receipts. The IRS can always audit you, of course, and unlike the program administrators of Flexible Spending Accounts (FSA’s), your Health Saving Account provider is not required to verify expense eligibility at time of withdrawal. Simply put, you are on your own.
So why are you telling me this?
The truth is we thought it would be nifty to create an app that not only captures all of your health documents, allowing you to tag and file to make retrieval a snap, but also to help you keep up with your health savings account balances and health receipts. We aren’t tax nerds, of course, but we know a few and think they are (kinda) cool. Cool enough to run a more optimized retirement portfolio strategy, anyway. Check it out here.
Happy Saving.
HSA Coach. Health is Wealth.
For more thoughts on investing, click here.
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