How to save $1 million completely tax free

My favorite retirement account is a Health Savings Account, or HSA.  I know, I’m weird.  But hear me out.

An HSA is the best of both worlds.  It has the benefits of an IRA (pre-tax funding) and a Roth IRA (tax-free withdrawals) as long as they’re used for health care related expenses.  And the advantages don’t stop there.

What many people miss out on is the third benefit: tax-free growth.

In practice, what I usually see is clients contributing to an HSA if they’re on an HSA eligible high deductible health plan (HDHP).  Some contribute roughly what they think they will use in a given year, similar to a Flexible Spending Account (FSA).  But unlike an FSA, you don’t lose any unused funds in an HSA.  They continue to accumulate until you decide to withdraw them.

Other clients contribute the maximum to their HSA and then use it for medical expenses as they occur.  Again, this is great, but they’re still missing that third benefit of tax-free growth.

And did you know you can reimburse yourself from your HSA for medical expenses incurred in previous years?  That’s right, previous years.

Let’s say you went to the ER in 2010 and had medical expenses of $5,000 out of pocket, which were not otherwise reimbursed or deducted as a medical expense on your 2010 tax return.  As long as you had the HSA established at that time in 2010, you can reimburse yourself from your HSA funds at any time.  So if you need the money now in 2021 and have sufficient funds in the HSA to cover it, you could take a $5,000 distribution completely tax free.

By keeping that $5,000 invested in your HSA from 2010 to 2021, you would have approximately $10,500 today, assuming a 7% return.  And that’s just over an 11-year period.

Now here’s where it really gets interesting: What if you and your spouse begin contributing to an HSA when you’re age 30 and continue contributing the maximum allowed each year until you turn 65?  Your total contributions over that 35-year period would be roughly $270,000.  And assuming the same 7% rate of return, your account balance would be worth approximately $1,087,961.  Even better, the cumulative tax savings, assuming a 22% federal tax rate, 5.75% state tax rate and a 7.65% FICA tax rate would be an additional $95,651.  If you were able to invest those tax savings each year, they would grow to over $385,000!

See the chart below (Exhibit 1).

I imagine right now you might be thinking, “But do I really need over $1 million that’s dedicated toward health care related expenses?”  Maybe.  Let’s see how you can use it:

• As mentioned above, you can reimburse yourself for qualifying medical expenses from prior years. If you averaged about $3,000 of out-of-pocket medical expenses over that same 35-year period, that would add up to $105,000.
• Fidelity estimated an average retired couple age 65 would need about $300,000 saved for health care expenses over their remaining lifetime.¹ So that puts us up to $405,000.
• According to Genworth, in 2020 the national average for a semi-private room in a nursing home facility was $7,756 per month, or about $93,000 per year, with some locations much higher than that.² Given that the average stay in a nursing home is 835 days³, that adds another ~$425,000 for a couple, bringing our total up to approximately $830,000.
• You can use HSA funds to pay for any COBRA premiums, Medicare parts B and D premiums, and long-term care insurance premiums (although there are limitations depending on your age).
• If you end up not needing all of the funds for health care, after you turn 65 you can withdraw HSA funds for any reason. The only caveat is if they are not used for qualifying medical expenses they are subject to income tax upon distribution.  In that case, the HSA would be just like your traditional IRA.

HSA’s can be even more valuable to early retirees since they typically are on a high-deductible health care plan prior to Medicare eligibility at age 65.  And while most qualified retirement plans are not accessible without penalty before age 59.5 (with some exceptions), eligible reimbursements from HSAs have no issues.

So there you have it – my favorite retirement account, the HSA.