Are HSAs the New IRAs?

Like Flexible Spending Accounts (FSAs), Health Savings Accounts (HSAs) allow you to set aside funds to pay out-of-pocket medical expenses. HSA-qualified expenses include co-insurance, deductibles, dental and vision care, prescriptions and many other health-related items.
Unlike FSAs, HSAs can help those in high-deductible health plans (HDHPs - see #1 below) sock away triple-tax-free money for qualified medical expenses in retirement.

Here’s how:

• Contributions to HSAs are tax-deductible. (see #2 below)
• Capital gains, dividends and interest accumulate tax-free. (see #3 below)
• You pay no tax on withdrawals for qualified medical expenses.

Other notable advantages of an HSA are that it’s yours to keep indefinitely (though you can no longer contribute once you’ve enrolled in Medicare or if you’re not covered by an HDHP), and any unspent money remains in your HSA until you use it. With an FSA, if you change employers you lose the account and forfeit any unspent money in your FSA at the end of your employment. Unspent money in your FSA doesn’t rollover to the new year, either—if you don’t spend the money by the end of the year, you forfeit it. 

If you use HSA funds on non-medical expenses before age 65, you pay both ordinary income tax and a 20% penalty. However, if you use HSA funds for non-medical expenses after age 65, you pay only ordinary income tax. In other words, you’d take no worse a tax hit than you would with an Individual Retirement Account (IRA).  Also, there is no Required Minimum Distribution (RMD) on HSAs as with Traditional IRAs. This allows you to withdraw as little or as much as needed to pay insurance premiums or qualified medical expenses regardless of your age. The longer you can allow the HSA funds to grow tax-free, the greater your benefit.

An HSA requires an account holder to name a beneficiary, just as you would with an IRA or 401(k). And similar to retirement accounts, the individual you name inherits the HSA after your death. Moreover, as with retirement accounts, you can name anyone as a beneficiary, including spouse, non-spouse, estate, etc. Naming an HSA beneficiary follows a number of guidelines for group retirement plans and IRAs—but that is generally where the parallel ends.
If your beneficiary is your spouse, then your HSA, upon death, becomes your spouse's HSA. The surviving spouse can continue to access HSA funds, and distributions for qualified medical expenses will be tax free, the same way they would be if distributed to the deceased account owner. However, beneficiaries other than a surviving spouse or the estate must include the full value of the HSA as taxable income in the year in which the account owner dies. So, unless you name your spouse as the beneficiary of your HSA, the account loses its tax-advantaged status as an HSA upon death of the account holder. The amount that is required to be included in gross income by any beneficiary (other than the estate) is reduced by the amount of qualified medical expenses that were incurred by the decedent prior to death and paid by the beneficiary within one year of death.
A non-spouse beneficiary does not have the option of establishing an inherited HSA, which means the option to “stretch” payouts is also unavailable. As a result, limited payout options could lead to receiving a sizable amount of income within a short time frame, potentially bumping a non-spouse beneficiary into a higher marginal tax bracket.
Sometimes an estate is named beneficiary of an HSA. Special rules apply here, too—the total distribution is included on the deceased account owner’s final tax return—not estate beneficiaries.
The bottom line 
Health Savings Accounts (HSAs) are a highly effective tax-advantaged strategy for medical expenses in retirement.

1. Defined as those with a minimum annual deductible of $1,400 for individuals and $2,800 for families. Enrollees can’t be enrolled in Medicare, claimed as a dependent on someone else’s tax return or covered by another health plan without a high deductible.
2. While HSA contributions are exempt from federal income tax, they are not exempt from state taxes in Alabama, California, New Jersey and Wisconsin.
3. State taxes may vary.