A Health Savings AccountHSAs are gaining popularity as investors plan for healthcare costs during retirement. HSAs allow you to make pre-tax contributions that grow tax-deferred. If you withdraw assets for a qualified medical expense, the withdrawal is tax-free—resulting in a trifecta of tax advantages.
Unlike a Flexible Spending Account, you don’t need to use the funds in an HSA within a limited time period to avoid losing them, and you can dictate how the funds are invested.
“For example, say you contribute money to an HSA and purchase a pair of eyeglasses in 2016 for $100 out-of-pocket. Assuming you can afford it, you choose not to request a reimbursement from your HSA until 2036, allowing compounding to work its magic on that $100,” said Jacklin Youssef, a senior wealth planning strategist in Vanguard Personal Advisor Services®. “If it grows tax-deferred for 20 years, earning a 6% average annual return, it will be worth more than $300 in 2036. You could submit the receipt for the eyeglasses you purchased 20 years ago and pocket $100 tax-free. The $200+ investment income you earned could be put toward other eligible medical expenses or remain invested.”
There are a few things to consider before investing in an HSA. First, you can only invest in an HSA if you sign up for a high-deductible healthcare plan (HDHP).
“Although HDHPs have low monthly premiums, they have high deductibles. Because the cap on your maximum out-of-pocket expense is higher, you may have to pay substantially more than someone with a lower-deductible plan if something unexpected occurs,” said Youssef.
Second, HSAs have a set contribution limit that’s subject to change each year. In 2016, HSA owners could contribute up to $3,350 a year for an individual and up to $6,750 a year for a family (catch-up contributions for individuals age 55 or over apply).
A Roth IRARoth IRA contributions offer no up-front tax benefit—meaning you can’t deduct your contributions from your income—but they offer income-tax-deferred growth, and tax-free withdrawals in retirement.* And unlike traditional IRAs, you don’t have to take required minimum distributions (RMDs).
“Roth IRAs are a great way to add tax diversification to your portfolio. Consider going beyond the ‘defer, defer, defer taxes’ mantra: Contributing to a Roth can increase your taxable income right now, but it will provide tax efficiency over the long term,” Youssef said. “Additionally, a Roth IRA can be a smart way to leave a legacy to an heir. Your beneficiary will be subject to RMDs, but the earnings won’t be subject to income taxes or penalties if the account has been open for five years or more.”
If you earn too much to make a Roth IRA contribution directly, you may want to consider converting a portion of your traditional retirement assets. “Contributing to a traditional IRA and converting the contribution to a Roth is an alternative way to invest in a Roth IRA, regardless of your income,” said Youssef. “I also encourage investors to see if their employer’s retirement plan provides a Roth option, since there are no income limits on making Roth 401(k) contributions.”
We can help you invest—and potentially lower your tax bill
Index funds and ETFsIndex funds and ETFs, by nature, are more tax-efficient than actively managed mutual funds because the underlying securities in index funds aren’t frequently traded. This results in fewer distributions that are subject to taxation.
Mutual funds are required to pass dividend distributions and profits they realize (when they sell shares of an underlying security) along to investors. Although investors aren’t selling shares directly, they’re still receiving investment income by way of a fund distribution—in the form of a dividend and/or capital gain.
If the fund that makes the distribution is held in a taxable account, the distribution is taxable in the current year. If the fund that makes the distribution is held in a tax-deferred account, the taxes are deferred.
“It’s also worth noting that a fund’s capital gains distributions are taxed at long-term capital gains rates, while dividend distributions may qualify for the preferred long-term capital gains rate if they’re qualified dividends,” said Youssef. “Long-term capital gains rates are generally lower than those for short-term capital gains, which are taxed at ordinary income tax rates. In 2016, income tax rates range from 10% to 39.6%, while long-term capital gains rates range from 0% to 20% (and may be subject to the Medicare surtax of 3.8%).”
*Withdrawals of earnings from a Roth IRA are income-tax free if you are age 59½ and above and have held the account for at least five years; earnings taken prior to age 59½ or five years may be subject to ordinary income tax, a 10% federal penalty tax, or both.
All investing is subject to risk, including the possible loss of the money you invest.
We recommend that you consult a tax or financial advisor about your individual situation.