By Mike Schultz, ChFC^®

Paying for healthcare expenses in retirement is a common concern. According to a recent survey (Transamerica Center for Retirement Studies), three of the top six retirement concerns of workers are health related: declining health, lack of access to adequate and affordable healthcare, and cognitive decline. Nearly all healthcare-in-retirement concerns carry a price tag—but a health savings account (HSA) is a smart strategy for alleviating some of that burden.

What is a health savings account?

An HSA is a tax-advantaged medical savings account for taxpayers enrolled in a high-deductible health plan (HDHP). Funds contributed to an HSA and growth of that money are not subject to federal income tax. When employed, the employee, employer, or both may contribute to the employee’s HSA. Money in your HSA account can help pay for your health insurance deductible and qualified medical, dental and vision care. When used for qualified healthcare expenses distributions are tax-free. Unlike a Health Reimbursement Arrangement (HRA) which is owned by employers, a HSA is owned by employees and is portable. HSAs stay with you until the assets are distributed.

Paying for healthcare expenses in retirement—tax-free and penalty-free

While you’re still working, it’s important to continue to contribute to your HSA for two reasons. First, assets in your HSA can grow, tax-free, to meet expenses many years in the future, in contrast to flexible spending arrangements where typically only $500 can be carried over to the next year. And second, once you retire and begin participation in any type of Medicare, you’re no longer eligible to contribute to your HSA. But you can still use the funds you’ve invested in it.

Prior to retirement, HSA funds used for non-qualified healthcare expenses are taxed at your normal income tax rate plus a 20-percent penalty. After retirement, there is no penalty for non-eligible HSA withdrawals. Beginning at age 65, you can use your HSA to pay the premiums for Medicare parts A, B and D, and Medicare HMO both tax-free and penalty-free. Should you opt to use your HSA to pay for non-qualified HSA expenses, you’ll be taxed at your normal rate but will not be subject to the penalty.

Special consideration after age 65

In order to remain eligible to contribute to your HSA after the age of 65, you cannot enroll in Medicare. A risk to HSA tax benefits is the automatic enrollment that occurs for Medicare Part A and Part B insurance on behalf of people receiving Social Security benefits at least four months before reaching age 65. As Medicare Part A and Part B are not considered high-deductible health plans, HSA eligibility is at risk if the HSA plan contributions continue after Medicare Part A and Part B insurance automatically begins due to the Social Security benefit initiation. Consult a qualified advisor for guidance in navigating Social Security and Medicare enrollment.

Risk associated with your health savings account

Another tax risk related to IRS rules on HSAs as they stand today is that inheritance of HSA assets by non-spouse individuals is taxable. So, it is important to have as part of your financial plan a strategy for spending HSA money. Compared with the average cost of healthcare in retirement—which Fidelity estimates to be $280,000 for a couple retiring today—creating an HSA spending strategy should not be a hinderance to using this tax-sheltered savings tool.