Who doesn’t love their HSA? Contributions are made with nontaxed money, investments build up free from current income tax, and distributions are tax free if spent on qualified medical expenses. As a savings vehicle they can’t be beat. In fact, savvy investors use these accounts primarily as a savings vehicle rather than the purpose for which they were created: to cover the deductible on the high-deductible health plans (HDHP) they are paired with.
The idea behind HSAs is this: Instead of having a health insurance policy with a low deductible and a high premium, you get one with a high deductible and a low premium. Then you set aside the funds you would have spent on premiums in a special account, to be used toward the deductible if you get sick. If you don’t get sick, the funds can stay in the account to grow.
Some people love their HSAs so much they don’t tap it even if they do get sick, instead paying expenses not covered by insurance out of pocket so they can leave the HSA funds to grow. There will always be plenty of medical expenses to be paid later in life, like Medicare premiums and long-term care services. Or you could even go back and reimburse yourself for expenses paid in prior years—for example, you could spend $1,500 out-of-pocket on a root canal in 2021 and reimburse yourself from the HSA ten years from now. This allows the $1,500 to earn ten years worth of investment returns. If you never use the funds they can go to your beneficiary at your death, free of probate but not free of tax. (Spouse beneficiaries can roll over an inherited HSA to their own HSA; nonspouse beneficiaries must pay tax on the full amount in the year of your death.)
It’s been said that you can’t contribute to an HSA once you turn 65. This is not entirely correct. What’s true is that you can’t contribute to an HSA once you enroll in any part of Medicare. If, when you turn 65, you are covered by an employer group plan that covers 20 or more employees, you do not have to enroll in Medicare. You can stay on the employer plan, and if the employer plan is an HDHP paired with an HSA, contributions can continue to be made to the HSA. Note: don’t enroll in Medicare Part A, which is free, if you are working and still wish to contribute to your HSA. Once you have any Medicare, you can’t contribute to HSAs anymore. Of course, once you turn 65 and government-sponsored insurance in the form of Medicare becomes available, you may want to give up the HSA in favor of Medicare. It will be important to do the math. (See below.)
Note that if you have retiree insurance (including Tricare for Life), COBRA, or an under-20 employer plan when you turn 65, you will have to enroll in Medicare because Medicare pays primary to those plans and Medicare won’t pay if you are not enrolled (and the plans won’t pay if Medicare doesn’t pay). This means there can be no further contributions to your HSA. You can keep the existing HSA and use it to pay medical expenses for yourself or your spouse.
Starting Social Security
Once you start Social Security benefits, if you are 65 or older you are required to enroll in Medicare. You can opt out of Part B if you are covered by an employer plan that covers 20 or more, but you cannot opt out of Part A. When you apply for Social Security, Part A will be made retroactive six months or back to age 65 if shorter. There can be no HSA contributions for any month in which you are enrolled in Part A. If contributions have already been made, they must be backed out. Any contributions made during any month of Medicare enrollment will be deemed taxable and subject to a 6% annual overcontribution penalty for as long as the contributions (and the investment returns thereon) remain in the account.
This means that any client age 70 or older will not be able to contribute to an HSA. Clients between the ages of 65 and 70 who are thinking of starting Social Security and who have an HSA will have to do some math. Remember that Social Security pays cash, while HSAs merely confer tax benefits. (Employer contributions to the HSA could also be considered cash, but they are really part of the salary package. Any client who must forego employer HSA contributions upon enrolling in Medicare should ask the employer for those same benefits to be paid in a different form.)
HSAs are individual accounts. But because they are sometimes paired with plans offering family coverage, confusion can arise when one spouse enrolls in Medicare either because of starting Social Security or the decision was made to have Medicare instead of the employer plan. Let’s consider some options using Jack and Jill as an example.
- Jack and Jill are both covered by Jack’s employer plan, which is an HSA/HDHP with family coverage. The full family contribution to the HSA for 2021 would be $7,200 plus another $1,000 catchup contribution for each spouse, for a total of $9,200. Let’s say Jack enrolls in Medicare and goes off the employer plan. Because Jack is the employee, when his coverage ends, so does Jill’s. She will have to find her own insurance. The HSA contributions will stop (prorated if Jack enrolls in Medicare mid-year) but each spouse can keep their respective HSAs to use for future medical expenses for themselves or each other.
- Jack and Jill are both covered by Jack’s employer’s HSA/HDHP, but this time Jill enrolls in Medicare. She decides to also remain on the employer plan. Since it’s a family plan, Jack (or the employer) can make the full family contribution of $7,200 plus Jack’s catchup contribution of $1,000. There can be no catchup contribution made for Jill.
- Same as #2 but instead of staying on Jack’s employer plan after going onto Medicare, Jill goes off that plan and entirely onto Medicare. Now Jack’s HSA/HDHP becomes an individual plan. He can contribute $3,600 plus his $1,000 catchup.
Medicare or HSA?
Clients between the ages of 65 and 70 who still work (or whose spouses still work) for an over-20 employer and who have not yet started Social Security have some choices. They can:
- Defer Medicare until the employer coverage stops (usually at retirement).
- Enroll in Medicare and keep the employer coverage, essentially having extra insurance. Medicare can even pay the deductible as long it’s for a Medicare-covered service and equal to or less than the Medicare-approved amount.
- Go off the employer plan entirely and have Medicare with supplemental coverage (Medigap plus drug plan or Medicare Advantage) as their sole insurance. Alert: If a spouse is also covered by the employer plan, clients should figure out alternative insurance for the spouse before dropping the employer plan.
If only this were a pure math problem: All you’d have to do is compare the benefits and costs of each option and choose the one with the higher benefit:cost ratio. Of course, the math itself can be rather involved, especially if the client’s income is high enough to trigger the income related monthly adjustment amount (IRMAA). Medicare might look like an attractive option, with its $148.50 monthly premium and $203 annual deductible, but once you add the IRMAA for a client who is still working, the monthly premium can be $475 or more (plus another $200 or so for Medigap).
The harder part is factoring in a client’s anticipated health care usage. HSA/HDHPs are ideal for people who are healthy and plan to stay that way. Then the insurance premiums stay low and all the tax-free HSA contributions can build up. But once clients start taking expensive drugs or need hospitalizations or costly procedures, Medicare can be the better deal. Then the objective is not to have a good savings plan but rather a good insurance plan.
Note that the drug coverage of most high-deductible plans is not creditable (Medicare’s term for a plan that is actuarially equivalent to Medicare’s basic drug plan design). This means clients who delay Medicare enrollment will pay a late-enrollment penalty when they eventually enroll in Part D. It amounts to about 35 cents a month for every month they went without Part D after age 65. The bigger issue, though, may be paying for the drugs themselves. Clients who take drugs and who factor these costs into the analysis may find that Medicare with a good drug plan beats the HSA/HDHP.
The one thing clients must not do when they turn 65 is nothing. Yet that’s exactly what a lot of people do if they are still working and happy with (or at least accustomed to) their employer insurance. Unless they are receiving Social Security, they won’t be notified that they are now eligible for Medicare. (This will change in 2023 with the passage of the Benes Act). HR won’t tell them, and their group insurance agent has no incentive to tell them. But the simple fact of now being eligible for Medicare opens up new options—and these may be more attractive than what they now have. At the very least clients need to understand the options, do the math, consider their expected health care usage, and prepare to switch to an entirely new health insurance system if Medicare turns out to be the best option.
Original article for an adviser newsletter by Elaine Floyd, CFP®, Director, Retirement and Life Planning, Horsesmouth, LLC, within which I’ve made edits for the broader public.