One of the keys to wealth building is protecting as much of your income as possible, making it crucial for high-income earners to develop a smart tax savings strategy. Health Savings Accounts (HSAs) are a great tool to help you accomplish this goal, yet they are often overlooked or misunderstood. When you do take advantage of an HSA – and you use it correctly – it provides an easy annual income tax deduction, but it can also create dedicated, tax-free savings for your healthcare needs in retirement.

Think of your retirement savings (IRAs and 401(k) as going to pay for other retirement expenses such as food, shelter, and clothes, and you can see that you need to jump-start saving in your HSA for your health care costs (including Medicare premiums) in retirement.  Moreover, an HSA is a savings account with a unique triple tax benefit. All contributions are tax-free, their growth within the account is tax-free, and qualified withdrawals (that is, ones that are used to cover qualified medical expenses) are tax-free, too.

Though this may sound promising, one-size-fits-all investment strategies don’t exist. Would an HSA make good financial sense for you? Read on to find out.

How HSAs Work

An HSA usually starts as a cash account that earns interest, with the option of becoming an investment account once it reaches the threshold balance. Currently (in the year 2021), these benefits are available for up to $3,600 for individuals or $7,200 for families, along with a $1,000 catch-up contribution for people at age 55 or older.

One of the many benefits an HSA provides is that eligible individuals can contribute to the account annually and the entire amount deposited is tax-deductible on returns for that year, even without submitting itemized tax returns. Additionally, contributions can be made by employees through payroll deductions and are made with pre-tax dollars, reducing your taxable income.  If your employer makes any contributions, the total employee’s and employer’s contributions cannot exceed the limit each year. 

The catch to an HSA is that to qualify for tax-free distributions, the money must be used to cover qualified medical-related expenses. Withdrawals are not taxed so long as they are used for qualifying expenses, including alternative healthcare treatments, prescriptions, co-pays, mental health, and addiction treatments, dental and vision care, long-term care insurance premiums, and Medicare premiums (not the premiums for a Medicare supplemental policy, such as Medigap). The IRS periodically updates the qualified expenses, so it’s a good idea to check with your insurer for the most current list.

SEE ALSO: Six Tax-Efficient Investing Strategies

Since there are restrictions on how you can use the funds in your HSA, it’s impossible to take full advantage of the tax-deferred and tax-free benefits of your account unless you give it time to grow. So, if you want to maximize your HSA as a tax-free investment account, you need to pay all your current medical expenses out of pocket, while simultaneously contributing to your HSA for potential future medical expenses in retirement.

It’s important to note that an HSA is only available for those who have a high-deductible health plan (HDHP). If you’re a high-income earner and you are relatively healthy, you should have this kind of health plan anyway, since you have the cash-flow needed to cover the cost of high deductibles and the tax benefits are greater for you.

Advantages of an HSA

Unlike Flexible Spending Accounts, HSAs have no use-it-or-lose-it feature. Funds carry over from year to year and are not lost if you change jobs or fail to use all the funds before the end of the calendar year, making HSAs a great savings vehicle for increasingly high medical bills that may occur during retirement. Additionally, after the age of 65, you may withdraw money from your HSA and pay the associated income tax. Though paying the tax isn’t ideal, the taxation works just like a traditional IRA, and there’s no penalty fee.

Given the fact that the average couple will need $295,000 to cover medical expenses in retirement, an HSA offers profound benefits when you are disciplined about funding it and avoiding withdrawals. An aggressive, high-income-earning 45-year-old saving the maximum per family plan, including catch-up contributions when eligible, could see total contributions of $152,000 by 65. Assuming the return is 6%,  the balance could rise to $275,000 by age 65.

An HSA can help Millennials prepare for retirement, as well. You may be trying to decide if you should fund your 401(k) plan or contribute to a HAS when both are available to you.  The HSA can be more beneficial than a 401(k) to maximize wealth accumulation.  Consider this: Pre-tax 401(k) plan distributions will be taxable in the future, and a Roth 401(k) requires using after-tax dollars to fund it to have tax-free distributions.  On the other hand, the HSA balance – funded with pre-tax dollars and distributed tax-free – can be distributed before age 59.5 without paying taxes and penalties.