A health savings account can be one of the most powerful tools in a retirement financial plan, but once you enroll in the program the rules change significantly, and ignoring those changes can set off tax bombs that are hard to recover from.
Here is what you need to know before your Medicare enrollment date arrives.
The contribution cutoff
The most critical rule is straightforward but frequently misunderstood. Once enrolled in any part of Medicare, neither you nor your employer can continue making contributions. Contributions made after enrollment are classified as excess contributions and subject to a 6 percent excise tax for every year they remain in the account. The earnings those excess contributions generate are also taxed.
The good news is that if you catch the mistake before filing taxes for that year, you can withdraw the excess contributions and their earnings and avoid the ongoing penalty, though the earnings must still be reported as income for that year.
The six-month lookback problem
This is where many people get caught. If you delay enrolling in Medicare past age 65 and later decide to sign up, your Medicare Part A coverage may be backdated by up to six months from your enrollment date. That means contributions you made to your HSA during those months would retroactively become excess contributions even if you were still working and had not yet formally enrolled.
To avoid this, stop contributing to your HSA at least six months before you plan to begin coverage if you are delaying past 65. And if you are 65 or older and start collecting Social Security benefits, that automatically triggers Part A enrollment, which triggers the same six-month lookback.
What you can still do with your HSA
Enrolling does not lock up the money already in your account. You can use existing funds to pay for a wide range of Medicare-related costs, including premiums for Part A, Part B, Part C (Medicare Advantage) and Part D prescription drug coverage. You can use those funds to cover deductibles, copays and coinsurance.
Medigap supplemental insurance premiums are the one notable exception and cannot be paid with HSA funds on a tax-free basis.
That balance can also continue to grow. Many providers allow you to invest a portion of your funds in vehicles like exchange-traded funds and mutual funds, and those investments grow tax-deferred even after contributions stop.
The 65 rule for nonqualified withdrawals
Before age 65, withdrawing HSA funds for anything other than qualified medical expenses triggers income tax plus a 20 percent penalty. After 65, the penalty disappears. You can use HSA money for any purpose after 65, including nonmedical expenses, and you will only owe regular income tax on the withdrawal.
How to prepare before Medicare begins
If you plan to enroll when you turn 65, stop contributing before the month of your 65th birthday. If your birthday falls on the first of a month, stop contributions the month before. Make sure your employer also stops payroll contributions at the same time.
If you are delaying Medicare past 65, stop contributions at least six months before your planned start date to avoid the backdating trap.
The account you have spent years building is still a valuable asset in retirement. The contribution phase is over once coverage begins, but the spending and growth phase can continue indefinitely.
