$1M in HSA is a rosy projection. But smaller savings still pay off

The goal of amassing $1 million in a health savings account by retirement will elude the vast majority of clients, but advisers could still put these optimistic projections to good use.

HSA holders would need to contribute the maximum legal amount each year, including catch-ups, for four decades, avoid any distributions until they're 65 years old and net a healthy rate of return of 7.5%, according to a study released last month by the Employee Benefit Research Institute, an industry research organization. Those rosy assumptions won't reflect the reality for most HSA savers. However, advisers can nevertheless nudge clients toward saving in their HSA with a wealth of statistical estimates showing their massive health care needs in retirement and the corresponding potential of the accounts as a savings vehicle, experts said.

To have a "high chance" of covering their medical expenses during their retirement, a 65-year-old couple must plan for $351,000 worth of Medicare premiums, deductibles and prescription drugs, according to the Institute's calculations. To boost the likelihood above 90%, that savings number grows closer to $400,000, said Jake Spiegel, a research associate with the organization and co-author of a larger report from the institute and health, wealth, retirement and employee benefits firm Inspira Financial last year that crunched the overall figures.

"After 40 years, you can end up with a significant chunk of change," Spiegel said. "HSAs could actually be pretty well positioned to help people to, one, save for retirement and, two, pay for medical expenditures in retirement which can be pretty significant."

Read more: How to help clients plan for the high costs of long-term health care

Those expenses can mount well before retirement, too. As advisers encourage clients to set aside the current maximum of $4,300 in 2025, take advantage of any employers' matching contributions and tap into the pretax savings, untaxed accumulation and tax-free withdrawals for qualifying medical costs, they should also remind them of the potential challenges, said Sarin Barsoumian, founder of Burlington, Massachusetts-based SMB Financial Strategies. Those include a huge potential tax hit to non-spouse heirs receiving any leftover assets after the clients' deaths and shortcomings in the investment menus and interest yields of many HSAs.

"Many clients use HSA funds for current medical expenses, but if they can afford to pay out-of-pocket, they should let the HSA grow tax-free for retirement. If they have a sufficient emergency fund and can cover medical costs without touching the HSA, they should consider investing the balance in a diversified portfolio," Barsoumian said in an email. "If clients withdraw funds for non-medical expenses before age 65, they'll owe income tax plus a 20% penalty — a much harsher penalty than early withdrawals from a traditional IRA or 401(k), which are just subject to income tax plus a 10% penalty. After age 65, non-medical withdrawals are taxed like a traditional IRA, but there's no penalty — so it's not as flexible as a Roth IRA for tax-free withdrawals."

Here are some of the most interesting takeaways from the EBRI research paper:

• Medicare paid for 61% of health care costs in retirement in 2021, with private insurance covering 18% and consumers paying out of their pocket for 12% of the expenses.
  

• A 65-year-old man using a Medigap plan that adds supplemental private health insurance for costs that aren't paid for by Medicare should expect to pay $184,000 for medical care in retirement, while a woman of the same age needs $217,000 and a couple should anticipate expenses of $351,000.
  

• Assuming the clients save the maximum each year in their HSAs and tack on $1,000 more in the permitted "catch-up" contribution years between ages 55 and 64 without withdrawing anything from the accounts, a 7.5% annual return on their assets would yield a nest egg of $78,000 in only 10 years. A 5% rate would add up to $68,000, and a 2.5% return would amass $59,000.
  

• With the same assumptions, the HSA balances would reach: 20-year totals of $120,000 (2.5% returns), $157,000 (5%) or $208,000 (7.5%); 30-year totals of $198,000 (2.5%), $303,000 (5%) or $476,000 (7.5%); or 40-year totals of $298,000 (2.5%), $540,000 (5%) or $1,029,000 (7.5%).
  

• Under less optimistic calculations that still incorporate a 7.5% return but assume the client withdraws half of the deductible amount from their HSA each year, the account would still have $56,000 after 10 years, $139,000 after 20 years, $311,000 after 30 years and $665,000 after 40.
  

• In terms of tax savings on their contribution, higher income HSA holders net $13,000 in lower payments to Uncle Sam over a decade, $24,000 over two decades, $34,000 over three and $45,000 over four. In terms of their savings on yields of 7.5%, they would avoid another $7,000 in taxes during the first 10 years, $29,000 over 20, $87,000 over 30 and $217,000 over 40.
  

The numbers shift significantly based on any number of factors, such as when a client opens an HSA and how long they are contributing to it, their tax bracket and the extent that they do spend the money on health costs before retirement.
"Past EBRI research has found that the longer someone has owned their HSA, the larger their balance tends to be, because the higher their contributions tend to be, and the more likely they are to invest their HSA in assets other than cash," Spiegel and the co-author, Paul Fronstin, wrote in the report. "These strategies better position accountholders to withdraw larger sums when unexpected major health expenses occur and can leave accountholders more prepared to cover their sizable health care expenses in retirement."

Read more: How HSAs pay off in retirement — with caveats

For advisers and their clients, the problem is "that does not appear to be a strategy that is widely deployed right now," Spiegel noted, citing another finding from the institute's research that only 13% of HSAs have invested assets in something other than cash.

"That number has been trending up every year that we've done our analyses," he said. "It's still nowhere near what you might expect it to be, given the enormous tax advantages that HSAs offer and the really unique position they offer as a triple-tax-advantaged vehicle."