Is This the Best Way to Save for Your Retirement?

By Markets Fool.com

When it comes to retirement savings, there are a few options: the 401(k), IRA, and several less common ones such as the 403(b), SEP, and SIMPLE IRA. Most people don't associate a Health Savings Account, or HSA, with retirement saving. However, it has many of the properties of tax-advantaged retirement savings accounts combined with additional benefits if you need to pay medical expenses in the meantime.

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What is an HSA and how do you start one?

An HSA, or Health Savings Account, is designed to help people with high-deductible health insurance plans pay for their out-of-pocket medical expenses. Unlike the Flexible Spending Account (FSA), an HSA allows account owners to roll over all unused funds year after year, and also allows account funds to be invested in mutual funds, similar to a 401(k).

These features make HSAs a great way to set aside money for healthcare expenses and save for retirement at the same time.

In order to open an HSA, you need to meet a few qualifications:

  • Most obviously, you need to be enrolled in a high-deductible health plan. For 2016, this is defined as a deductible of at least $1,300 for single coverage or $2,600 for family coverage. And your out-of-pocket maximum must be at least $6,550 (single) or $13,100 (married).
  • You can't have any additional health plans that don't meet the high-deductible requirements.
  • You can't be enrolled in Medicare.
  • You can't be claimed as a dependent on anyone else's tax return.

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HSAs are offered by many major financial institutions, so a good place to start your search is your own bank.

Like a traditional IRA, with extra tax advantages

The tax structure of an HSA is similar to that of a traditional IRA or 401(k). Contributions are tax deductible in the tax year they were made, and can be made until the tax deadline of the following calendar year. For example, contributions for 2016 can be made until April 15, 2017.

Also, like a traditional IRA, invested HSA funds can grow and compound on a tax-deferred basis until they are withdrawn. Once withdrawn in retirement, the distributions from the HSA are counted as taxable income.

The bonus tax benefit occurs when the account funds are used to pay qualified healthcare expenses, in which case the withdrawal is tax-free as well. This is true at any age -- not just in retirement. So, when used to pay for healthcare, account holders get the tax deduction benefits of a traditional IRA and the tax-free withdrawals of a Roth IRA.

Contribution limits

For the 2016 tax year, HSA account owners with single health coverage can contribute up to $3,350 to their account, and those over age 55 can contribute an additional $1,000. If you have family health coverage, your HSA limit for 2016 is $6,750. There is a $1,000 additional "catch-up" contribution allowance for family HSAs, as long as the head of the household is over 55.

Using money from an HSA

As I mentioned, any money you use from your HSA for qualified healthcare expenses can be withdrawn 100% tax-free. And there are several ways you can do this. Many people have a debit card or blank checks linked to their account, which simplifies the process. For example, if you need to pay for a prescription, simply swipe your HSA's debit card and do it.

Or you can choose to pay the expenses out of pocket and then reimburse yourself. One interesting feature of the HSA is that there is no time limit for reimbursements -- you can wait as long as you'd like. In other words, you can pay a large medical bill out of pocket and leave your money in your HSA to grow and compound tax-free until you need the reimbursement.

Once you reach retirement age, the healthcare spending restriction disappears, and you are free to withdraw your money penalty-free (but not tax-free) for any reason. It's important to note that the "retirement age" for HSA purposes is 65, not 59 1/2 like with an IRA.

Finally, if you make a non-qualified withdrawal from your HSA before age 65, you'll be subject to a stiff 20% penalty from the IRS. This is double the 10% early withdrawal penalty you'd face when withdrawing funds from a traditional IRA or 401(k), so it's important to be aware of this consequence.

What are "qualified" healthcare expenses?

There is a long list of qualified expenses that can be found in IRS Publication 502, but just to name a few of the most common ones, you can use HSA funds for:

  • Doctor's visits
  • Dental treatment
  • Prescriptions
  • Eyeglasses, lenses, and exams
  • Fertility treatments
  • Hearing aids and batteries
  • Operations/surgery
  • Nursing services
  • Physical therapy
  • Psychiatric care

HSA or IRA?

Both types of retirement accounts have their own pros and cons that you should evaluate in order to make the best choice for you and your family. For example, if you're single, the $5,500 IRA contribution limit is higher than what you'll be able to put in your HSA. And with an IRA, you'll be able to use the money penalty-free for retirement more than five years sooner.

However, I feel that the healthcare tax benefits of an HSA could outweigh any drawbacks for a majority of Americans. So, take a look at the benefits of an IRA, compare them with those of an HSA, and choose the best savings option for you.

The article Is This the Best Way to Save for Your Retirement? originally appeared on Fool.com.

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