The Secret Retirement Planning Account That Could Save You Tens of Thousands

Source: Wikimedia Commons.

There's a group of folks out there I like to call Retirement Planning Ninjas. This obscure group of warriors has figured out some of the best, most tax-advantaged and tricky ways to save up tons for retirement.

Last year, while preparing my taxes, I came upon a website that promotes a method that has unheard-of benefits: putting money into an investment account tax-free, letting it grow tax-free, and then pulling it out -- tax-free. It turns out some mainstream financial sites have caught on as well.

That kind of benefit has me so excited that I've already talked my wife into using this account in hopes that it could help pave the way for an early retirement.

But you might be surprised to learn that this isn't some form of IRA, or even a company-sponsored 401(k) or 403(b). Instead, this secret account that people rarely view as a retirement tool is...

A Health Savings Account
That's right: It is, in fact, a health savings account that has the potential to yield some pretty awesome benefits. But there are some rules you need to play by to reap these benefits, so pay attention closely and make sure using an HSA for retirement purposes is appropriate for your own individual situation.

Let's start with the basics. A health savings account is available to folks who have high-deductible health-insurance plans. Such plans are currently offered by UnitedHealth (NYSE: UNH  ) , WellPoint (NYSE: WLP  ) , and Humana (NYSE: HUM  ) , among others. And as far as HSAs go, "high-deductible" means at least $1,250 for individuals and $2,500 for families.

Whenever you have to pay out-of-pocket expenses for medical care, you can either pay directly from your HSA account (via a debt card) or reimburse yourself for the payment at a later date. Every year, individuals can contribute a maximum of $3,300 to their HSAs, while families can contribute $6,550.

There are two enormous benefits that HSAs have that their Flexible Spending brethren don't. First, any money unused at the end of the year isn't lost; it's simply rolled into the next year. Second, while money is sitting in an HSA, it can be invested in much the same way that money in a 401(k) can.

So how does this help me with retirement?
There are a few keys to making this arrangement work in your benefit. The first is that the IRS doesn't designate when you have to reimburse yourself for out-of-pocket medical payments. Because of this, you can simply pay for a medical expense out of pocket and wait months -- if not years -- to reimburse yourself. In the meantime, that money stays in your HSA and grows over time.

For instance, last year my wife and I had to pay for the birth of our daughter out of pocket because there were no health insurance options available on the marketplace that would cover us. In total, it was about $5,000.

We were fortunate enough to have that money available, but we paid it out of pocket instead of using our HSA money or reimbursing ourselves. We did that because we'd rather give that $5,000 time to grow -- tax-free -- until we need to take it out.

When that time comes -- possibly when we put a down payment on our first house -- we can draw that money out (tax-free) and use it as we please. Remember, in the government's eyes, we are simply paying ourselves back for maternity costs, even if the costs were incurred years ago.

Any money that's left over in the account thanks to capital growth can stay there and be used at a later date when we decide to reimburse ourselves for other expenses.

As you might expect, the higher one's deductible is, the more beneficial the plan can become, barring a medical catastrophe. That's because HSAs can't be used to reimburse premiums -- only out-of-pocket medical expenses. The higher the deductible, the more likely you are to have out-of-pocket expenses, and the easier it is to recoup that tax-free money.

The most important thing to remember is that receipts and records must be kept in case you're audited and need to justify all medical expenses should, and you must ensure that these expenses are never reimbursed by any other party or used in an itemized deduction on your taxes.

But what if I don't spend that much on medical expenses?
Obviously, if you stay healthy throughout your life (good for you!), this plan might not sound too enticing. Indeed, if you withdraw money for nonmedical expenses, you'll be faced with a 20% tax penalty.

At least, that's the case until you turn 65, at which point the penalty is gone and your HSA basically becomes a traditional IRA. You'll still be taxed on any disbursements you take that aren't for medical expenses, but at a much lower rate that's comparable with what you'd be paying on, say, a 401(k).

Of course, its important to balance the benefits of traditional IRAs (especially when there's an employer match), Roth IRAs (which allow you to extract your principal five years after it was inserted at no cost), and HSAs before diving in and maxing out your contributions. And remember: It's clear that HSAs were never meant to be used primarily as a retirement tool.

But retirement savings is clearly a benefit that's underused, and with the onset of Obamacare and its higher-deductible plans, it's one that you should seriously consider.

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Read/Post Comments (14) | Recommend This Article (8)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 08, 2014, at 9:54 AM, halcyon3 wrote:

    I thought you could withdraw principal from a Roth IRA at any time without penalty. I'm sure that's what I've read elsewhere. I was planning to make an early withdrawal soon so I will need clarification on that.

  • Report this Comment On March 08, 2014, at 9:59 AM, halcyon3 wrote:

    From U.S. News and World Report:

    If you opened a Roth IRA last year, and contributed $5,000...Under Roth IRA rules (check IRS Publication 590 for more information), you can withdraw up to $5,000 without paying taxes on it, and without paying a penalty. Once you dip into your earnings – that $272.50 – the story changes. You can withdraw what you have contributed at anytime, and for any reason. So, if you have contributed $5,000 a year faithfully for the last three years, you now have $15,000 available to you from your Roth IRA...You don’t have to worry about penalties and taxes as long as you avoid dipping into your earnings.

  • Report this Comment On March 08, 2014, at 10:03 AM, Svapnadarzana wrote:

    question I have with the HSA is your artice said it cannot be used for premiums, does this include medicare supplemental? and or long term care insurance in retirement? tax free

  • Report this Comment On March 08, 2014, at 10:04 AM, TMFCheesehead wrote:

    @halcyon3-

    Here' a link to the rules: http://www.schwab.com/public/schwab/investing/retirement_and...

    If the money was put into your account as a Roth IRA from the beginning (not a conversion) you can withdraw your principle tax-free. But you cannot withdraw any earnings without imposing a penalty.

    If it was a conversion, it is my understanding that it had to be classified as a Roth for at least 5 years.

    Hope that helps, and make sure to read from the link carefully,

    Brian Stoffel

  • Report this Comment On March 08, 2014, at 10:11 AM, TMFCheesehead wrote:

    @svapnadarzana-

    Here's a link to the IRS site for full reading: http://www.irs.gov/publications/p969/ar02.html#en_US_2013_pu...

    As far as I understand, long-term care insurance can be used as a qualified medical expense. Medicare supplemental does not qualify.

    See this link for specifics: http://www.irs.gov/publications/p969/ar02.html#en_US_2013_pu...

    Hope this helps,

    Brian Stoffel

  • Report this Comment On March 08, 2014, at 10:36 AM, Svapnadarzana wrote:

    thanks Brian, Maybe I am reading only what I want to read ( lol) but the wording from the IRS makes it sound like I can use the HSA tax free to pay for Medigap or supplemental ins after the age of 65 when you would normally qualify?.

    also it appears we could be using the HSA to pay premiums now for long term care insurance? we are in our mid fifty's and have approx 50K in the HSA at this point, and I read we could get a cheaper premium for long term if we bought now instead of waiting until we hit 60+ ??

  • Report this Comment On March 08, 2014, at 10:53 AM, TMFCheesehead wrote:

    @svapnadarzana-

    The wording is pretty convoluted (surprise), but I don't think you can use it for Medigap. Taking out the in-between words, here's what I see:

    "You cannot treat insurance premiums as qualified...expenses unless...they are for...Medicare (OTHER THAN premiums for Medigap."

    Also, there are limits for how much of your premiums can be used for long-term care. If you are in your 50's, the most you can deduct is $1,360.

    Here's the link for those limits: http://www.irs.gov/instructions/i1040sca/ar01.html#d0e203

    Brian

  • Report this Comment On March 08, 2014, at 11:20 AM, TMFCheesehead wrote:

    As @nails_moore pointed out to me via Twitter, if you're taking out large enough sums of money from your Traditional IRA/401(k)/403(b), your tax rate may be higher than 20%, in which case it may actually be more advantageous to withdraw $$ before you hit 65 and don't plan on using it for medical expenses.

    Brian Stoffel

  • Report this Comment On March 08, 2014, at 1:07 PM, SegMil wrote:

    While I agree an HSA is a viable option to shelter funds & let them grow, there's no mention of fees associated with these accounts. It's not as simple as just depositing funds. There can be account set-up & closing fees, monthly statement/maintenance fees, minimum balance requirements, & transaction fees each time an investment is chosen or changed, etc.

    If circumstances change & one becomes insured under a current or new employer, with no HAS option, your individual HSA could sit there incurring charges that far outweigh your investment returns.

    I opened a HSA this year & spent HOURS researching & asking questions. Since my current situation is quite uncertain, I opted for a no-fee what-so-ever account that offers NO investment options, but does pay a lousy interest rate. When I know more, I can always move to another HSA account.

    In response to @halcyon3-, you most certainly CANNOT withdraw when you feel like it and go unscathed. Go to the source---the IRS Pub. 590--look at figure 2.1 under the Roth provisions---you must have a QUALIFIED distribution. Your example of $5,000 contributed each year over the last three years & then taking a distribution of $15,000 in the fourth year? Unless you meet an exception, your $15,000 will not be taxed for INCOME TAX purposes but absolutely you will be hit with a 10% penalty, even with earnings intact. The law is very clear about a 5 year account requirement. And, yes, any conversion from a "traditional" account starts a new five year period.

    Btw, while IRS Pubs. can't be used as precedent (law), they are guidance that one can use to explain a position to an IRS agent. However, if one says, "US News and/or Schwab said...", the agent, while not saying it, will look at you like you've lost your mind. And, here's another warning, read the Pub. more than once & read it on different days---often what you read and how you understand it will differ. The info. starts to sink in & you will then read and understand more clearly, and make sure you read EVERYTHING that relates to it----don't stop when you've reached an answer you LIKE---keep reading to see if there're other requirements.

    Of all things certain, besides death & taxes, there's only one answer to every tax question anyway, and that answer is: "It depends...."

  • Report this Comment On March 08, 2014, at 1:50 PM, TMFCheesehead wrote:

    @halcyon3-

    SegMil is correct: even if the money wasn't rolled over, the principle must have been in the Roth for 5 years to bring it out tax free.

    A link to the IRS code:

    http://www.irs.gov/publications/p590/ch02.html#en_US_2013_pu...

    Brian Stoffel

    P.S. Thanks for the input, SegMil

  • Report this Comment On March 08, 2014, at 3:58 PM, hopper wrote:

    There is yet another benefit to HSAs that isn't mentioned in the article. Unlike IRAs and 401(k)s, the amount that you contribute to an HSA from payroll deductions is exempt from FICA taxes, which currently (2014) is 6.2% for Social Security on your first $117,000 of income and 1.4% for Medicare on all your income. Granted, this may hurt you on the other end when generating your Social Security benefit calculations.

    For example, suppose you earn $100K and contribute $5,000 to an HSA via payroll deductions. You'll save $370 on FICA taxes ($5,000 X 7.4%). If you make over $117K, then you'll save $70 ($5,000 X 1.4%) since you've already paid the maximum amount for the Social Security portion of FICA taxes.

    You get this FICA exemption only when your contributions are deducted from payroll. If you contribute to an HSA independently then you still get to deduct it from your AGI but it won't be exempt from FICA.

  • Report this Comment On March 09, 2014, at 7:17 AM, pobox2001 wrote:

    Brian,

    I believe you and SegMil are incorrect regarding removing your own contributions (not conversions) to a Roth. Yes, Fig. 2-1 discussed "qualified distributions", however a return of your contribution is not considered a "qualified distribution."

    Clicking on your link to Pub 590, look 3 paragraphs earlier, to a section entitled "Are distributions taxable?" It begins, "You do NOT include in your gross income qualified distributions OR DISTRIBUTIONS THAT ARE A RETURN OF YOUR REGULAR CONTRIBUTIONS from your Roth IRA(s)." (EMPHASIS added) "Qualified distributions" or not the same as "Distributions that are a return of your regular contributions," thus the reason they are listed individually.

    Here's a link with a easier to understand write up: http://fairmark.com/retirement/roth-accounts/roth-distributi...

    Thanks,

    pobox2001

  • Report this Comment On March 09, 2014, at 11:31 AM, TMFCheesehead wrote:

    @pobox2001-

    This is why I love the Fool. Education always taking place.

    Alas, I will conclude my own input by saying that consulting a tax expert (note: I'm not one) about removing principle from a Roth before 5 years have passed is by far the best advice I can offer.

    You guys are awesome,

    Brian

  • Report this Comment On March 09, 2014, at 1:34 PM, Maximizese wrote:

    My wife and I switched from a PPO ($420/month) to a HDHP ($180/month) with HSA about 3 years ago. We're in our early 30s and only use about $700 in health expenses outside of our premiums. We've contributed ~$18,000, but the the gains in the investments have moved our balance to $24,000. Chase, our administrator, charges a $2.50 monthly maintenance fee, but no transaction fee. So I take advantage of this by incrementally buying in on our investments based on S&P technicals.

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