Health Savings Accounts as Retirement Savings Plans

When people think of tax-free retirement savings, they think of IRAs and 401(k)s. The problem with those, however, is they are taxed.  Either the distributions are taxed at retirement or the contributions are taxed when earned.  Health Savings Accounts (HSAs) do not share that problem. 

HSAs do come with one big problem, however.  You cannot contribute unless enrolled in a high-deductible health plans (HDHP).  HDHPs are generally considered cheap but undesirable—who wants a high deductible?  For higher income individuals, however, that may not be a deal breaker. 

Health Savings Accounts and IRAs

A health savings account (HSA) is a trust or custodial account set up for a beneficiary.  HSAs can be set up through an employer’s cafeteria plan. They can also be set up by individuals on their own. As with an IRA, an HSA itself is exempt from paying income tax except on unrelated business income.

HSA balances belong to the beneficiary.  Unused amounts are not forfeited each year as they are with a Health Reimbursement Account or Flexible Spending Account. They accumulate into the future the same as they do with an IRA.  In fact, most of the financial firms that offer IRAs also offer HSAs.

HSA distributions are excluded from gross income, but only if they are used exclusively to pay for qualified medical expenses.  There are no required minimum distributions.  There is no early withdrawal penalty if distributions are used for qualifying medical expenses.  Distributions that are used for other things are taxed, and for those under age 65 taxed an additional 20 percent.

With traditional IRAs or 401(k), an individual deducts or excludes contributions from income, but pays tax on future distributions. With Roth IRAs or 401(k)s, an individual does not deduct or exclude contributions, but does not pay tax on future distributions. HSAs provide the best of both: contributions are deducted or excluded, and no tax is owed on future distributions.

Health Plans are Far More Tax Advantaged Than Retirement Plans

The taxation of HSAs reflects the extraordinarily tax-advantaged roots of employer and health plans.  As with compensation, employers deduct their contributions to their employee health plan from their income. But unlike compensation, employees exclude the contribution from their income. Moreover, employees do not pay tax on the actual medical benefits from an employer health plan.

Comment: This is untaxed money that is otherwise left on the table, and the reason employer health plans are popular.  HSAs differ from traditional employer plans in that individuals have the option of setting them up outside of an employer plan. In that sense they resemble IRAs.  But they are still taxed as if they were employer health plans.

Contributions to HSAs

Contributions are either deductible if made by an individual or excluded from income if made by an employer. 

For 2020, the limit for an individual enrolled in a single person HDHP is $3,550, and $7,100 for family HDHP coverage.

Unlike IRAs or employer plans, individuals can contribute even if they do not have earned income.  Individuals cannot contribute after they enroll in Medicare. 

Individuals can fund their HSA with a rollover from another HSA.  They can also do a one-time only rollover from an IRA. In that case, however, they are limited to the inflation adjusted maximum contribution amount that that year.

For most people with HSAs, contributions will be offset by health expenses over time.  Unusually healthy or lucky individuals might accumulate a substantial balance.  For families living paycheck to paycheck, it might make sense not to accumulate too much in an HSA as there might be better uses for the money (e.g., paying down credit card debt).    

Letting Accumulations Ride

A question arises, however, about whether it makes sense for individuals who have surplus income to purposely avoid drawing down HSA account balances.

A strong case can be made for paying medical bills out of available cash instead taking it out of the HSA. This might be a no-brainer for those who have already contributed the maximum annual amount to their IRA and 401(k).   

Even if the choice is between taking money out of taxed investments and taking it out of an HSA, it can make sense to take it from taxed investments.

Example.  In 2020, Mary is enrolled in an HDHP with a $2,000 deductible.  She has a $10,000 balance in her HSA. She also has $10,000 in a taxable brokerage account. She gets sick and is billed for $2,000 in medical expenses representing her deductible.  Instead of drawing out $2,000 from her HSA, she takes it from the brokerage account.  As a result, she must pay $300 in capital gains tax in 2020.  Her total cost is $2,300 to pay a $2,000 medical bill.  However, in return for that $300, the untouched $2,000 in the HSA grows completely tax free until she decides to take it out for medical expenses which could be decades. 

Unused HSA Balances

Retirees generally have no shortage of uncovered medical bills.  Financial advisors generally tell middle class clients they will need to budget $10,000 a year for medical expenses during retirement.  So even if one has six figure HSA balance, it will likely get used.

At death, any balance is passed onto a named beneficiary.  Beneficiaries who are surviving spouses can treat the HSA as their own.  Other beneficiaries such as an estate or family member take the balance and treat it as current income.  They pay tax on the fair market value of the account balance on the date of death. The taxable amount is reduced by the deceased’s qualified medical expenses in the year of death. 

Comment: HSAs for surviving spouses are a good deal, but not for anyone else who inherits.  Even with the SECURE Act curtailment of life expectancy distribution period for inherited IRAs, IRAs remain a far better way to pass on wealth to the next generation.

HSA v IRA for Retirement Investments

HSA contributions clearly make sense for those who are already contributing the maximum amount to their retirement accounts.  One cannot have too much money growing tax-free. But what if the choice is between contributing to an HSA and an IRA or employer plan?

Advantages of HSAs include:

  • HSA money is not taxed either when contributed or distributed;
  • no RMDs;
  • no penalty for early distributions if they are used for medical expenses;
  • no earned income requirement—one does not need to have a job to contribute.

Advantages of IRAs or employer plans include:

  • employer plans such as 401(k)s often have a matching feature;
  • money can be used for anything, not just medical care; and
  • beneficiaries of inherited accounts have at least five years to take distributions to smooth out income.

Comment: A common strategy for prioritizing contributions to these plans is to first contribute enough to one’s employer plan to get any match offered. Then contribute the maximum HSA amount. Then contribute the rest to an IRA or employer plan.  

So, if HSAs are so great, why are they not as popular as IRAs?

The Price of Admission: HDHPs

HSAs can only be set up and used by people who are covered by a high-deductible health plan (HDHP). An HDHP is a health plan with:

  • an annual deductible of at least $1,400 for 2020 for self-only coverage, or $2,800 for 2020 for family coverage; and
  • an annual out-of-pocket expenses limit of $6,900 for 2020 ($7,000 for 2021) for self-only coverage or $13,800 for 2020 ($14,000 for 2021) for family coverage.

Out-of-pocket expenses include deductibles, co-payments and other amounts (other than premiums) that must be paid for plan benefits. The individual can have other coverage as well, but it is narrowly limited.

What’s so Special About HDHPs?

From a health policy perspective, HDHPs address the “moral hazard problem” that accompanies insurance. The idea is someone whose costs are fully insured will not shop for price or value when consuming services.  If it is free to them, then of course they will choose the best even if they would never choose it if they were paying.

For example, someone might leave their car parked in an exposed spot on a busy street because it is insured.  When it is smashed, there is an inconvenience factor in filing a claim and getting the car fixed.  But it will be fixed as good as new for almost free.  Good thing too, because shops charge a fortune.  That is why auto insurers provide big discounts for big deductibles.    

In the health insurance context, it might mean going to the emergency room rather than waiting for a doctor’s appointment or opting for the more expensive test procedure.  Why not, it is free.  With a big deductible, however, people think twice before they would do that. 

Comment: “Moral hazard” is a bit controversial—not everyone thinks people are that calculating or that good at calculating even when they try.  But it is taken seriously at the public policy level.  The arguments legislators have over unemployment benefits is grounded is a pure moral hazard argument: if you pay people not to work, they won’t. The calculation for this might be different in a pandemic when you want people to stay home. But for many even in a pandemic, this is a problem. 

Of course, however one comes down on the public policy of moral hazard, at the individual insured level having a large deductible is a problem rather than a feature. These policies may be cheap, but Congress knew it had to sweeten the deal if HDHPs were to become common. With an HSA, very tax-favored money from either the individual or the employer is there for deductibles.

Comment: The moral hazard problem is addressed because one has the option of keeping the money in the HSA rather than spending it on medical care.  People are better consumers, the thinking goes, if they have some skin in the game.  In any case, higher income individuals can easily afford to pay these deductibles.


Unlike retirement plans, HSAs are truly tax-free.  The only downside is one must be enrolled in an HDHPs to contribute. These plans not bad, however, for those who can easily afford the deductibles.  

By James Solheim, J.D.

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All stories by: CCHTaxGroup