Introduced in 2003 as a tax-preferred way for working Americans to pay out-of-pocket health care costs, Health Savings Accounts (HSAs) are today gaining popularity as a versatile retirement savings tool.

An HSA lets you save money to pay out-of-pocket health care costs in a more tax-advantaged way. This year, you can contribute up to $3,650 to an HSA for yourself or up to $7,300 for a family. If you're 55 or older, you can contribute an extra $1,000.

“An HSA is a great emergency fund," says Griffin Geisler, a wealth planning consultant for RBC Wealth Management-U.S. in Minneapolis. “And one of the most common emergencies you'll run into is a health emergency."

From 2020 to 2021, HSA assets jumped 19 percent to nearly $98 billion and the number of HSA accounts rose 8 percent to top 32 million, according to HSA investment advisory firm Devenir.

While the prevalence of employer-sponsored high-deductible health care plans (HDHP) is one reason for the jump (HSAs are offered in tandem with such plans), wealth planning experts say more people are funding HSAs as they would a retirement savings account.

“Because of tax leverage, fully funding an HSA on an annual basis is an excellent financial planning decision," says Alan Wolberg, a senior wealth planner at City National Bank. That's especially true for Baby Boomers (people born between 1946 and 1964) facing rising health care costs — projected to increase nearly five percent per year, according to data from the Centers for Medicare & Medicaid Services — in retirement.

Do the math

An HSA is tied to a high-deductible health insurance plan (HDHP), which is designed to protect you from catastrophic medical costs from things like a car accident or cancer. But you pay more of the day-to-day expenses through a higher deductible and higher out-of-pocket (deductibles, copayments and coinsurance) maximums. This year, the HDHP deductible for yourself is $1,400 or $2,800 for a family, on average. The limit on out-of-pocket expenses is $7,500 per person or $15,000 per family.

That might sound scary, but an HDHP's lower monthly premium combined with an HSAs tax benefits often offset the higher premium of a traditional Preferred Provider Organization (PPO).

“The biggest hurdle in making that decision is the high deductible," Geisler says. “If you're used to a $50 copayment, it's tough to write a big check for medical expenses under a high-deductible plan."

How can you determine whether an HDHP/HSA or a PPO is best for you? Compare plan premiums, deductibles, out-of-pocket costs and tax-free savings options. Check if your employer offers a matching HSA contribution. Then, do the math. If the difference between premiums is close to the HDHP deductible after your employer's incentive, choose the HDHP/HSA.

Don't forget to consider how healthy you and your family are, how often you visit a doctor, how many prescriptions you fill and if you expect any significant medical costs like pregnancy or surgery.

Pros and cons

The triple tax benefit of an HSA puts it in a league of its own. Your contributions are pre-tax, which reduces your income; funds grow tax-free; and withdrawals made from the account and used for qualified medical expenses are distributed tax-free.

“An HSA is tax-free-in and tax-free-out," Wolberg says. “That makes it incredibly tax efficient."

Other HSA benefits include:

  • Anyone can fund your HSA
  • An HSA stays with you if you change jobs or health plans
  • Money in the HSA rolls over each year, unlike a Flexible Spending Account
  • HSA dollars can pay for long-term care insurance premiums*
  • You're allowed one lifetime rollover from an IRA into an HSA, so money that would be taxable becomes tax-free when used for medical expenses
  • If you're 65, you can use HSA funds for any purpose without penalty, but payments are taxed as ordinary income. Before 65, if you withdraw HSA dollars for a non-medical expense, you'll pay taxes plus a 20 percent penalty

If your employer doesn't offer an HSA or you're self-employed, you can open one on your own. HSA Search lets you compare hundreds of options, fees, investment choices and ratings.

Growing HSA dollars

HSA deposits earn interest and grow over time. Once your HSA reaches a healthy balance, Geisler recommends investing it to make the money grow faster. Choose your investment options, such as CDs, bonds and mutual funds, based on whether you think you'll need to access the money, he says.

The tax benefits of an HSA far outweigh retirement accounts, where contributions (Roth IRAs) or distributions (401(k)s and traditional IRAs) are taxed.

Let's say someone in the 24 percent tax bracket contributed $6,900 to an HSA each year (increasing contributions by 2 percent a year) and invested the money for 20 years at an annual return of 4 percent. The tax-free HSA would grow to $258,404 vs. $234,317 in a taxable account, according to Geisler.

As an investment strategy, he suggests contributing to a 401(k) or IRA up to your employer's match amount, then contribute the maximum to your HSA and, if you can, max out your retirement contributions.

"Diversification is a good idea for investments, and it is also great to diversify your account by how they are treated for taxation purposes," explains Geisler. "Having a more diverse pool of accounts from a tax standpoint allows you to take withdrawals from tax-free accounts, when withdrawals from a traditional IRA, for example, will tip you into another tax bracket or increase your income to where you lose tax incentives."

“There's really nothing else like an HSA," Geisler adds.

*Subject to some limitations

Read more from our RBC Wealth Insights report Taking control of health care in retirement.

City National Bank is a subsidiary of Royal Bank of Canada.

RBC Wealth Management and City National Bank, their managed affiliates and subsidiaries, as a matter of policy, do not give tax, accounting, regulatory or legal advice. Rules in the areas of law, tax, and accounting are subject to change and open to varying interpretations. You should consult with your other advisers on the tax, accounting and legal implications of any proposed strategies based on your particular circumstances.

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