HSA – The Only Tax Trifecta

HSA: the only tax trifecta and a possible alternative to Long Term Care Insurance.

Since HSAs were created in 2003, their popularity has been growing steadily. If you have a High Deductible Health Plan: minimum annual deductible of $1,200 for individual and $2,500 for family coverage, you may qualify for an HSA. Additional requirements are: you cannot have other health coverage, nor be enrolled in Medicare nor be another taxpayer’s dependent.

We all heard from our wise elders that the only two things certain in life are death and taxes! To encourage retirement savings, we are afforded certain tax advantages in qualified retirement accounts most commonly in IRAs, 401(k)s and 403(b)s. With these, your contributions are tax deductible and they can grow tax-free until you get taxed when you withdraw them in retirement. If your contributions are made in Roth accounts, you pay taxes first, your contributions will grow tax-free and your withdrawals are tax-free. So our generous taxman gives us a tax break so that our retirement account can grow tax-free but takes his dibs either when the contributions are made or when they are withdrawn.

But with a HSA, the tax advantage is trifold in that 1) your contributions are tax deductible, 2) they grow tax-free and 3) your withdrawals are also tax-free as long as they are used to pay for qualified medical expenses. These are the reasons why HSA is often called Medical IRA except with three instead of the typical two tax advantages. Note that outside of HSA, the only medical expense deduction you can claim is if your medical expenses are above 10% of AGI threshold.

With an increased life expectancy of the average American, more of us are concerned about outliving our retirement savings or having our retirement savings get wiped out by long term health care costs that seemed to have far outpaced other inflation rates. Many have been turning to long-term care insurance to mitigate the effect of this outcome or to have peace of mind one or two decades down the road. Of course long-term care insurance has its own issues, the biggest drawback being the cost. As the saying goes, those who can afford it don’t need it, and those who need it can not afford it. In addition the insurance companies can hike premiums after your purchase. Also a typical LTC insurance has 90 day deductible period which means if your stay in a nursing home is less than 90 days your LTC will not pay you a dime.

So if you are closer to ‘those who can afford’ rather than ‘those who need’ it, an alternative might be that you can use a HSA to specifically fund your long-term care needs. Let’s say you are a 50 yr old married couple, contribute to a HSA the maximum of $6,650, including catch up of $1,000 from age 55 till age 65 and not withdraw but allow your account balance to grow at the rate of 3% after inflation. Your HSA balance would grow to $197,356 by age 75, $228,789 by age 80 and $265,229 by age 85.

This may be one-way to self-fund your long-term care needs at least partially. Again as long as your withdrawal is to pay for qualified medical expenses, it is tax-free and you can pay for either spouse’s long term care needs. Should you not need any long term care needs, you can pay for other qualified medical expenses. Note that the withdrawals not related to qualified medical expenses will be taxed at an ordinary income tax rate but without 20% penalty after 65.

If you are maxing out all other available retirement contributions, a HSA might be an excellent alternative to the high cost of long-term care insurance due to the tax advantages it offers.