Don’t wait for Congress to act to help your clients with health care planning in retirement. Regardless of what comes out of Washington, we know that health care costs will be significant in retirement. Advisers can play an important role addressing the issue now by communicating the benefits of health savings accounts.

For clients to gain the maximum benefit from their HSA at retirement, they must rethink how they view the account and how they use it. Instead of seeing their HSA as their go-to fund for immediate medical needs, they should view their HSA as an additional form of retirement savings.

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A large percentage of many retirees’ savings will go toward health care costs. A recent study by the Employee Benefits Research Institute found that some couples would need almost $350,000 to cover medical expenses during retirement.

An HSA can be a valuable tool to pay for these expenses. If clients fund an HSA yearly now and do not use the funds for current medical expenses, the funds can accumulate significantly and help pay medical costs in retirement.

An HSA provides an opportunity to pay medical expenses in retirement with tax-free dollars. Clients get the triple benefit of a deduction when they make the HSA contribution, tax-free buildup inside the HSA and tax-free distributions.

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Clients with HSAs get a tax-free deduction when they contribute to the account, tax-free buildup inside the HSA and tax-free distributions for medical expenses.

Most clients with HSAs use them inefficiently. What usually happens when clients have an HSA is that whenever they have a qualified medical expense, their first thought is to turn to the HSA. In the process, they lose out on the opportunity of tax-deferred growth and, perhaps more important, they lose out on potentially larger tax-free distributions in retirement.

The smart HSA strategy is to finance the HSA as early as possible and as much as possible but then to avoid tapping it until retirement.

What if the client has medical needs? It’s hard to imagine getting through life, especially if children are around, without prescriptions to fill and trips to the emergency room. For those expenses, clients should be encouraged to use other non-HSA funds, if they have the means to do so.

QUALIFIED MEDICAL EXPENSES
Owners can access their HSA tax-free and penalty-free to pay for qualified medical expenses at any time, including after they retire and stop making contributions. Generally, qualified medical expenses are those that are eligible for the medical expense deduction on a tax return. This includes most medical, dental, vision and chiropractic expenses.

Clients may take tax- and penalty-free distributions to pay for their spouses’ or dependents’ medical expenses as well as their own. This is true even if the spouse or dependent has his or her own medical insurance that is not HSA-eligible. HSA owners can even take a tax- and penalty-free distribution in the current year to reimburse themselves for medical expenses in a previous year, as long as the expenses were incurred after their HSA was established.

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Once clients are age 65 or older, distributions for nonmedical expenses are no long subject to penalty. What older investors use the fund for does not matter.

When clients reach age 65, they gain some new benefits with their HSAs. Generally, insurance premiums are not considered qualified medical expenses. After age 65 and enrollment in Medicare, however, certain insurance premiums can be paid tax-free with HSA distributions. For instance, clients can pay for all Medicare premiums except Medigap.

If a distribution is taken from an HSA and the funds are not used for qualified medical expenses, there is a 20% penalty that applies. But for clients who are age 65 or older, HSA distributions are no longer subject to penalty. What you use the funds for does not matter.

HSA CONTRIBUTIONS WITH MEDICARE
When it comes to making contributions to an HSA when clients reach age 65, things can get a little tricky because of the complicated interaction of the HSA rules with Medicare.

To be eligible to contribute to an HSA, a client must have a High Deductible Health Plan. They cannot have coverage under another plan that is not an HDHP. Because Medicare is not an HDHP, they cannot contribute to their HSA if they are enrolled in Medicare. Enrollment in any Medicare coverage (Parts A, B, C, D, or Medigap) will end HSA eligibility.

A client loses his eligibility to make an HSA contribution as of the first day of the month he turns age 65 and enrolls in Medicare. He can make a pro-rated contribution to his HSA for the months before he became ineligible due to enrollment in Medicare. This contribution can be made up to the HSA contribution deadline, which is generally April 15 of the following year.

HSAs AND SOCIAL SECURITY
Social Security can add another wrinkle. If a client claims Social Security at age 65 or later, she will also be automatically enrolled in Medicare Part A. This means that she is no longer eligible to contribute to an HSA because she no longer has an HDHP.

Things get even more complicated for workers who decide to delay receiving Social Security benefits. If a client claims Social Security and therefore is enrolled in Medicare Part A after reaching age 65, his enrollment is backdated by six months. However, it cannot be backdated below age 65.

Consider this example: Margot files for Social Security at age 68. Upon filing for Social Security, she is automatically enrolled in Medicare Part A and her enrollment will be backdated six months. If Margot made HSA contributions in any of those six months, they would be considered excess contributions.

Many clients delay retirement until after age 65 and keep working. They do not claim Social Security. If they have an HSA, may they still contribute to it?

Well, it depends upon whether they are enrolled in Medicare. Some clients may opt out of Medicare and receive health-care coverage through their employer. By opting out of Medicare, if the employer offers a HDHP, the client can continue to contribute to their HSA.

HSAs AND IRAs
Generally, HSAs and IRAs are totally separate types of accounts and they cannot be mixed in any way. You cannot roll over or transfer HSA funds to an IRA and vice versa.

But, as in almost all things retirement related in the tax code, there is an exception. An individual is allowed to transfer funds from an IRA to an HSA up to the remaining contribution amount allowed for the year. In order to be able to do this, the individual must comply with numerous restrictions on the transfer. The transfer is called a qualified HSA funding distribution, or QHFD.

The IRA funds can be moved to the HSA account only as a direct transfer. They cannot be moved as a 60-day rollover. In addition, an individual may do only one QHFD in his or her lifetime, even if he has multiple IRAs. IRA accounts can be combined before the QHFD to be able to transfer the maximum amount.

Here’s an example: Monty has two IRAs with balances of $4,000 and $6,000. He wants to do a QHFD this year for his HSA contribution limit of $6,750. Neither one of his IRA accounts holds that much. Since Monty can only do one QHFD, he will have to combine his IRAs into one account and then do his QHFD from the single IRA, which would have a balance of $10,000.
An exception to the one-time-only rule exists for individuals who have self-only coverage on the first day of the month in which the QHFD occurs but who switch to family coverage later during the year. They can do an additional QHFD to cover any remaining difference between the self-only contribution limit and the family contribution limit.

The transfer can come from an HSA owner’s traditional IRA, Roth IRA, inactive SEP or Simple IRA. The transfer can go only between IRAs and HSAs owned by the same individual. The funds transferred must be pretax funds. The distribution is an exception to the pro-rata rule for IRA distributions. The use of Roth IRA funds for a QHFD will be extremely limited as a Roth IRA will generally be mostly after-tax funds.

The amount that can be transferred as a QHFD is determined by the contribution limit for the HSA owner. He can transfer up to the total amount of his contribution limit for the year, minus any contributions already made. The owner cannot take a tax deduction for the QHFD.

The QHFD becomes a taxable distribution if the individual no longer qualifies for an HSA during a period beginning on the first day of the month when the QHFD was made and ending on the last day of the 12th month after that month.

For instance, Greg did a QHFD in March of 2017. He must remain eligible for an HSA for the period beginning on March 1, 2017, and ending on March 31, 2018. There is an exception if his failure to remain eligible is due to his death or his disability.

A QHFD is a tax-free distribution of IRA funds to an HSA. The client gets to shift taxable funds to an HSA, which can then make tax-free distributions to the client for qualified medical expenses. Because it is a tax-free distribution, it is also not subject to the IRA 10% early distribution penalty.

A QHFD can also be made from inherited IRAs. The QHFD will be subject to all the restrictions noted above.

Ed Slott

Ed Slott

Ed Slott, a CPA in Rockville Centre, New York, is a Financial Planning contributing writer and an IRA distribution expert, professional speaker and author of several books on IRAs. Follow him on Twitter at @theslottreport.