Can Early Retirees Buy Coverage with HSA Funds? Answer: Yes. . . and No.
by your Health Savings Academy | Originally posted on LinkedIn
Early retirement sounds great and may look financially viable. But don't forget to consider the cost of medical coverage and care.
A small number of financially disciplined Americans are following to the FIRE (Financial Independence, Retire Early) movement in which adherents sacrifice some discretionary purchases in the present to, in effect, buy retirement before age 65 (Medicare eligibility), almost age 67 ("full" Social Security benefit) or 70 (maximum Social Security benefit). Others have never heard of FIRE but are tired of work or unable to continue employment in a physically demanding job and thus leave the work force and earned income.
Regardless of the reason for ceasing to work before age 65, early retirees have a lot of financial considerations to weigh (whether they do so or not). And medical coverage should be near the top of that list. Whether they've planned for this expense or never thought about it, they're likely to face - often for the first time - a world in which their employer isn't making decisions for them (such as sponsoring one or two plans) or heavily subsidizing their premiums.
Here are some important considerations for early retirees who've funded a Health Savings Account:
Distributions Are Always Permitted
It's important to note that no one - state or federal government, employer, or account administrator - can prevent a Health Savings Account owner from withdrawing funds at any time to reimburse any expense. Thus, an owner can withdraw funds for any medical premiums.
The issue with all distributions is whether they reimburse a qualified expense. If they do, the withdrawal is tax-free. If not, the distribution is included in taxable income and subject to a 10% additional tax unless the owner is disabled or has attained the age of 65 (or has died and her heirs are reimbursing expenses incurred before the owner died).
Thus, the answer to the question posed in the headline is "yes." But usually the hidden implication in such a question is whether the distribution is tax- and penalty-free. The answer to that question may be "no."
Proper Planning
Early retirees must think seriously about how to pay the cost of coverage (insurance) and care (out-of-pocket expenses for services received) before they leave permanent employment. They may end up paying $700 or more in premiums alone for self-only coverage and $1,500 or more to add a spouse to their coverage. In addition, they'll have cost-sharing (deductibles, copays, and coinsurance) and services that aren't covered (like dental and vision services).
The good news is that Health Savings Account owners with funded accounts can always withdraw funds tax-free to pay for qualified medical expenses like cost-sharing on their medical, dental, and vision coverage, plus other expenses that diagnose, mitigate, cure, prevent, or mitigate an injury, illness, or condition (like over-the-counter remedies and medically necessary services not covered by insurance).
The question is whether the cost of coverage is a qualified expense that entitles the owner to distribute funds tax-free to reimburse those premiums. The answer depends on the nature of the coverage.
Assessing Forms of Coverage
Early retirees may have a range of coverage choices. Here are the financial implications of withdrawing Health Savings Account to pay premiums for some options:
COBRA. Most employees who leave employment are entitled to continue their coverage through a provision in the Consolidated Omnibus Budget Reconciliation Act (COBRA), a mid-1980s budget bill. Most people entitled to COBRA continuation can remain covered on the group plan for 18 months if they pay a premium of up to 102% of the price of coverage for active employees. This amount can represent sticker shock, as employers subsidize the premium for active employees. But it may be less expensive than coverage in the nongroup market that's priced based on age.
COBRA premiums can be paid with tax-free distributions from a Health Savings Account.
COBRA enrollees who are HSA-eligible (enrolled in an HSA-qualified plan and meet other eligibility retirements) can fund a new or existing Health Savings Account - including contributing and turning around and immediately withdrawing the funds to pay their COBRA premiums.
Nongroup coverage. Early retirees can purchase coverage in the nongroup market as well, either through a federal- or state-facilitated marketplace (often referred to as public exchanges or by the brand name of a particular state's program, such as the Commonwealth Connector in Massachusetts). This coverage is expensive for early retirees because the premium varies with age, though early retirees might qualify for premium subsidies financed from the federal treasury to which five of every six nongroup enrollees is entitled. Nongroup coverage is an option when COBRA isn't - either because a person's eligibility for COBRA continuation has expired or the early retiree wasn't entitled to COBRA continuation.
If the subscriber is collecting federal or state unemployment benefits (in what might be referred to as involuntary early retirement), nongroup coverage premiums can be paid with tax-free distributions from a Health Savings Account. Otherwise, nongroup premiums are not a qualified expense, and all withdrawals to pay nongroup premiums are included in taxable income (and assessed the additional 20% tax as a penalty unless the account owner is disabled or has reached age 65).
If the nongroup plan is HSA-qualified and the early retiree meets other eligibility requirements, she can fund an existing or new Health Savings Account with tax-deductible contributions to reimburse current (including that month's premiums) and future qualified expenses tax-free.
Spouse's group plan. Some early retirees may have the luxury of a younger (or older) spouse who continues to work and remains enrolled on employer-sponsored coverage. In that case, the spouse pays the premium for coverage, almost always through payroll deductions from her paycheck. Those deductions are almost always made through the company's Cafeteria Plan, so they're pre-tax.
Group coverage is never a qualified expense for Health Savings Account withdrawals. That's fine - they're already tax advantaged through the Cafeteria Plan, so the account owner can preserve balances to pay qualified expenses like medical-plan cost-sharing and dental and vision expenses.
If the plan is HSA-qualified and the early retiree meets other eligibility requirements, she can fund a new or existing Health Savings Account. Spouses must split the family contributions ($7,300 limit in 2022), though they can determine how much of that amount is deposited into each Health Savings Account. An early retiree age 55 or older who meets all eligibility requirements can always make the $1,000 catch-up contribution into her own account.
Short-term, Limited-Duration Plans. This coverage is offered to individuals, though these plans are regulated by states and may be difficult to access where you live. They're designed to bridge gaps between more traditional coverage (like group-plan-to-group-plan, or group-plan-to-Medicare). Premiums are typically lower than comparable plans offered in public marketplaces because they offer fewer benefits (a 60-year-old early retiree might not have coverage for maternity services, for example). Also, they're underwritten, which means that issuers choose whether to extend coverage and price the plan for individual applicants based on medical condition. Thus, some early retirees may not qualify for coverage and others may pay a higher premium than they would for public-marketplace coverage (which must accept all applicants, regardless of medical condition).
Premiums for this form of coverage are not a qualified expense. Distributions are included in taxable income and may be assessed the additional 20% tax. These plans are never HSA-qualified, so enrollees can't fund a Health Savings Account.