By In Do the Math, Health Financial Accounts, Health Savings Accounts (HSAs), Retirement Income, Retirement Investment Accounts, Savings

Doing the Math on Why You Should Max Out Your HSA Contribution

Here are The Benefits of FI, we talk about HSAs as a savings vehicle for retirement in the same vein as a 401(k) or IRA. That’s because it has the same basic features of enabling pre-tax savings to be invested and thereby grow at a significantly higher rate than post-tax dollars in a standard checking or savings account.

What some of you, especially those who have just started you FI journey and have neither started a family of your own nor seen your own parents get to standard retirement age, may be thinking is that since you’re saving the money for retirement, it’s retirement income that you’ll get to spend on fun stuff. Hopefully that will be true (although you’ll get taxed on it), but odds are that you’ll use it for medical expenses, which are never as fun but almost always a factor.

Research by Fidelity Investments, reported by Money, shows that the average couple currently reaching retirement age will incur $280,000 in medical-related expenses in retirement. As homer Simpson would say:

If your plan is to retire earlier? You’ll have considerably more health-related expense, especially if you have children — even if everyone is perfectly healthy.

Sidenote: For those following the “Medicare for All” debate, that amount is with Medicare and no additional coverage like Medicare Advantage or Medicare Supplement plans…so don’t think “Oh hey, we’ll just get M4A and I won’t have to worry about it!”

The punchline, as you have probably guessed by now, is that you should max out your HSA, even if it means putting a bit less toward your retirement account. Why? Because HSAs remain tax-free even in retirement IF you use the funds on medical expenses. That means that your HSA funds will be worth at least 15 percent more than other retirement savings.

Here is an illustration of what that savings can look like:

The 2019 HSA contribution limit is $3,500 for individuals and $7,000 for families. Let’s assume you give the family limit starting at age 24, and your goal, conservatively, is to retire when you’re 45 years old. At a modest return rate (5 percent) and tax bracket (29 percent combined federal/state), your HSA balance looks like this:

Annual Contribution$7,000
Return rate5%
Tax bracket24%
HSA Balance$269,537

As you see, you’re a little more than halfway to what the experts say you’ll need for medical expenses.

Three quick caveats:

  • This model assumes $0 of your HSA is being used for medical expenses as you go, i.e. you’re saving every penny you can and not touching those funds, so if you have to go to the doctor you’re paying “out of pocket” with taxed dollars;
  • On the positive side, the annual HSA contribution limit goes up about 3-5 percent each year, so it’s likely you’ll be saving much more in year 16 than you did in year 1; but
  • Health care costs go up roughly the same year-over-year, if not more. So by the time you reach retirement, it may be more like $350,000 or much, much higher that you’ll need to pay toward health expenses, with or without M4A.

With that said, we know that the major medical expenses — outside of a medical emergency, which we’ll cover in another post — usually don’t start kicking in until you’re in your 50s and 60s, and even if you retire, you can contribute to your HSA and get a tax refund at the end of the year, which you can then turn around and contribute the following year. So, if you start saving when you’re 24 and keep saving until you’re 54, it (conservatively) could look like this:

Annual Contribution$7,000
Return rate5%
Tax bracket24%
HSA Balance$946,622

Yowza! So, with the caveats I mentioned above, if you keep contributing the maximum you can, you should have plenty of money to pay for unforseen (but expected) medical expenses. You could even start paying for your health insurance with your HSA balance, since it’s tax-free, and still contribute the max and have a very comfortable nest-egg for future medical expenses. Then, the value of the HSA kicks in as well because if you want to use excess funds for something else, like travel or other fun stuff, you can withdraw it and it’s taxed like any other retirement income.

That’s why, if you have the means, you should take a look at an HDHP with HSA and max out your contribution starting as young as you can!

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