HSA in Retirement: A Breakdown of the Rules

A Health Savings Account (HSA) is a tax-advantaged savings vehicle for individuals with high-deductible health plans. During working years, it offers a triple-tax benefit: contributions are tax-deductible, funds grow tax-deferred, and withdrawals for qualified medical expenses are tax-free. As individuals enter retirement, the regulations surrounding an HSA evolve. The rules governing contributions, withdrawals, and inheritance change, making the HSA a versatile financial tool in retirement.

HSA Contribution Rules in Retirement

The ability to contribute to an HSA is directly tied to an individual’s enrollment in Medicare. Once a person is enrolled in any part of Medicare, including Part A, they are no longer eligible to make contributions to an HSA. This rule applies even if the individual maintains coverage under a high-deductible health plan.

For the year an individual enrolls in Medicare, contributions must be prorated. The total allowable contribution is determined by the number of months the person was HSA-eligible before their Medicare coverage became effective. For instance, if Medicare coverage begins on July 1, the individual can only contribute for the first six months of the year.

Some individuals may work past age 65 and delay Medicare enrollment if they have creditable health coverage through an employer. In this scenario, they can continue to make full HSA contributions, including any catch-up contributions. However, if an individual applies for Social Security benefits after their full retirement age, Medicare Part A coverage can be made retroactive by up to six months. This would make them ineligible for HSA contributions during that period, potentially creating excess contributions that must be corrected to avoid tax penalties.

The additional catch-up contribution of $1,000 is available to eligible individuals aged 55 and over, but this must also cease upon Medicare enrollment. If both spouses are over 55 and not enrolled in Medicare, they can each make a $1,000 catch-up contribution into separate HSA accounts.

Using Your HSA for Qualified Medical Expenses

A primary function of an HSA in retirement is to serve as a tax-free source of funds for healthcare needs. Withdrawals are free from federal income tax as long as they are used for Qualified Medical Expenses (QMEs). As defined by Internal Revenue Code Section 213, QMEs are broadly defined and cover a wide array of services and products for diagnosing, treating, or preventing disease.

For retirees, a significant advantage is using HSA funds to pay for certain insurance premiums. Account holders can use their HSA to pay for Medicare Part B (medical insurance), Part D (prescription drug), and Medicare Advantage (Part C) plan premiums. This provides a tax-advantaged method for covering these regular retirement healthcare costs. Premiums for Medicare Supplement Insurance, known as Medigap policies, are not considered qualified medical expenses.

HSA funds can also be used for long-term care. Account holders can withdraw money tax-free to pay for qualified long-term care services, such as assistance with daily living activities. Additionally, funds can be used to pay premiums for qualified long-term care insurance policies. The amount treated as a QME for these insurance premiums is subject to annual, age-based limits set by the IRS.

Non-Medical Withdrawals After Age 65

A significant rule change for HSAs occurs when the account holder reaches age 65. Before this age, any distribution not used for a qualified medical expense is subject to both ordinary income tax and a 20% penalty. For account holders age 65 or older, this 20% penalty is waived, allowing for withdrawals for non-medical purposes.

This provision allows the HSA to function similarly to a traditional retirement account, such as a 401(k) or IRA. An individual can withdraw funds for any reason, such as travel or living expenses, without the penalty. This transforms the HSA into a dual-purpose account, serving as a dedicated fund for healthcare and a supplemental source for other financial needs.

While the penalty is removed, any amount withdrawn for a non-qualified expense will be included in the individual’s gross income for that year. This amount is then taxed at their ordinary income tax rate. Distributions for qualified medical expenses remain completely tax-free, preserving the primary tax advantage of the account.

HSA Beneficiary Rules

The treatment of an HSA after the owner’s death depends on the named beneficiary, leading to distinct tax outcomes.

If the designated beneficiary is the surviving spouse, the ownership of the HSA transfers to them, and the account maintains its status as a Health Savings Account. The surviving spouse can then use the funds tax-free for their own qualified medical expenses, just as the original owner did. The account simply rolls over, preserving its tax-advantaged status.

When the beneficiary is a non-spouse individual, such as a child, the account ceases to be an HSA upon the owner’s death. The fair market value of the account becomes taxable income to the beneficiary in the year the owner died. The beneficiary can reduce this taxable amount by using the funds to pay for any of the decedent’s final medical expenses within one year of the death.

If no beneficiary is named or the owner’s estate is the beneficiary, the outcome is the least favorable. The account is closed, and its fair market value is included as taxable income on the decedent’s final income tax return. This can result in a significant tax liability for the estate.

Managing and Accessing Your HSA Funds

Most HSA administrators provide several methods for paying for expenses. These include an HSA-linked debit card, checks drawn from the account, and online bill pay features that allow direct payments to medical providers.

A key feature of the HSA is the flexibility of its reimbursement process. A retiree can pay for a medical expense out-of-pocket and then reimburse themselves from their HSA at any point in the future. There is no time limit for this reimbursement, as long as the expense was incurred after the HSA was established.

The responsibility to prove that HSA withdrawals were for qualified medical expenses rests with the account holder. In the event of an IRS audit, the individual must be able to provide documentation for every tax-free distribution.

It is important to keep a detailed log and copies of all receipts for medical expenses paid with or reimbursed by the HSA. This documentation substantiates the tax-free nature of the withdrawals and ensures compliance with IRS regulations.