Is a Health Savings Account an IRA in Disguise?

For healthy people with a neat row of financial ducks and plenty of cash, health savings accounts, or HSAs, could be a retirement gift from the tax gods.

It's no secret that the body begins to break down in old age, leading to an abundance of medical expenses. A recent study by Fidelity Investments put the average dollar amount needed for this purpose at a jaw-dropping $220,000 per couple.

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What if you could fund a retirement account specifically earmarked for health care costs?

In theory, very precocious savers could accumulate up to $360,000 after saving in an HSA for 40 years, assuming a 2.5% return, according to a study by the Employee Benefit Research Institute, or EBRI. A 7.5% rate of return nearly triples that figure to $1.1 million.

For those who are eligible, it pays to learn all the health savings account rules, both good and bad.

HSAs actually surpass IRAs -- even Roth IRAs -- in their tax blessings. They have a triple tax advantage compared with the measly two tax benefits offered by individual retirement accounts. There are just a couple of (really big) catches.

Triple crown tax treatment: Why you want an HSA

HSAs enjoy three tax advantages:

HSA Pros

  • Money goes in pretax or contributions are tax deductible.
  • Once in the account, money grows tax-free.
  • Money can be withdrawn tax-free to cover qualified medical expenses.

"The buildup is tax-free, so whatever earnings you get on the account -- whether it's interest earnings or if you invest the money in stocks or mutual funds or some type of brokerage account -- that builds up tax-free and when money comes out for qualified medical expenses, it's tax-free," says Paul Fronstin, Ph.D., director of the health research and education program at EBRI.

"It's different than a traditional 401(k) plan where the money goes in tax-free, builds up tax-free but is taxable upon distribution," he says.

Drawbacks to HSAs

Truly, the tax gods give with one hand and slap you with the other. HSAs are a tax-break treasure -- but only for those who can afford to take full advantage of them. The rules for health savings accounts can be stringent.

First of all, to even qualify for an HSA, you must purchase a high-deductible health plan. These are not "Cadillac" health care plans with generous benefits. The minimum annual deductible, according to the IRS, is $1,250 for individuals and $2,500 for family coverage.

Those deductibles and corresponding out-of-pocket expenses are what HSAs are designed to help you out with. So, for those who'd like to use HSAs to save for retirement or future health care expenses, the biggest hurdle to overcome is present-day medical expenses. The people who can benefit most from the lavish tax advantages of HSAs basically must either be incredibly healthy or have a lot of cash on hand to cover today's health care costs while letting their savings grow tax-free over time.

Here are a few other health savings account rules that limit their usefulness:

HSA Cons

  • The money is earmarked strictly for medical expenses or penalties may be imposed. Withdrawals used for nonqualified medical expenses before someone becomes eligible for Medicare are subject to both income taxes and a 20% penalty.
  • After age 65 or Medicare eligibility, withdrawals for nonmedical expenses are not subject to the 20% penalty, though they are subject to income taxes, just as they would be from a traditional IRA.
  • Contributions to the account can only be made up until an individual hits Medicare eligibility. Turning 65 doesn't automatically disqualify you from contributing to an HSA, but enrolling in Medicare as the primary source of insurance does.

Medicare eligibility is generally age 65, "but it can also happen when someone qualifies for Medicare through being on Social Security disability," says John Grosso, senior vice president in the health and benefits practice at Aon Hewitt.

HSAs are also a bit hamstrung by low contribution levels. The contribution limit in 2014 is $3,300 for an individual and $6,550 for family coverage. People over age 55 can put in an extra $1,000 per year in catch-up contributions.

HSA Hacks: Tips and Tricks

Everyone loves a good loophole, and there are a couple around the HSA. For instance, HSA distributions don't have to be taken in the year the expense is incurred. That means that money tucked safely inside an HSA can keep growing tax-free -- provided, of course, that you can cover the deductible on your health insurance plan and any out-of-pocket expenses when they are incurred.

"Keep a list of your qualified health care expenditures and receipts. Then, when you need money to pay for your kid's college, take the vacation you always wanted -- even before age 65 -- you can pull it out of the account and report an equal amount of health care expenditures from prior years on your tax Form 8889 for that year," says Matt Rinkey, president of Illumination Wealth Management in San Diego.

Only one hitch: HSA distributions won't cover health care expenses incurred before you establish an account.

Another trick is only useful for savers between the ages of 59 1/2 and 65 who own traditional IRA or 401(k) assets.

By taking withdrawals from an IRA or 401(k) and putting that money directly into an HSA, people can nearly wash out the taxation on those dollars, according to Grosso.

"It's a little clumsy. You take the money out, pay tax and then put the money in the HSA and take a deduction. It's not a complete wash, but it's another way to build up assets in the HSA," he says.

You're going to be paying for health care anyway. Tax-free money might make the mountain of health care expenses waiting in retirement a little more easily scaled.

Copyright 2014, Bankrate Inc.