Can HSAs Help Bridge Coverage Gap for Early Retirees? Yes, but.

You can't reimburse nongroup premiums tax-free from your Health Savings Account. But that's not the end of the story.

Talk about sticker shock! As more Americans build a nest egg to retire before age 65 to pursue passions, travel, or just exit the pressure of the corporate world for a leisurely retirement, many find that they forgot to consider one major budget line item: medical coverage. They can file for Social Security benefits as early as age 62, even though their full retirement age is 66 years and 10 months (born in 1959) or 67 years (born 1960 and later) to supplement retirement income from other sources.

However, there is no early enrollment option for Medicare. They can't enroll in the federal program for coverage of the elderly until they reach age 65. They're not required to purchase medical coverage at the federal level (though some states impose this mandate). They place a lifetime of accumulated assets at risk, however, if they choose not to protect themselves against a catastrophic loss like a heart attack, cancer, or liver failure. Thus, medical insurance is a financial necessity.

How to pay for coverage, particularly if you haven't budgeted this item? You can't (in most cases) pay nongroup premiums tax-free from your Health Savings Account. However, you can employ some strategies to reduce your net premium cost by strategic use of your Health Savings Account balances - particularly if you've been a diligent saver during your working and funding years.

COBRA Premiums

If you continue your group plan by exercising your rights under COBRA, you can pay those premiums with tax-free withdrawals from your Health Savings Account. The premium is expensive - typically 102% of the full premium. On the one hand, you'll experience sticker shock because your company (almost certainly) will no longer pay its portion of the premium. Imagine thinking you'll continue to pay your $150 monthly payroll deduction plus the 2% admin fee ($153), only to realize that your company paid 75% of your premium. Your full premium is $600 plus the 2% admin fee, or $612 monthly.

On the other hand, you're most likely paying a bargain price for coverage. Most companies set fixed employee premiums for all workers on the same product with the same contract tier (for example, self-only, employee+spouse, or family). In other words, a 25-year-old and you - at least three decades older) each pay, in our example above $150 per month in payroll deductions for medical premiums, even though older workers on average incur much higher claims.

If, instead of opting for COBRA, you chose a plan in the nongroup market (through a federal- or state-facilitated marketplace, a private marketplace, or an insurer), your premium would reflect your age. You may pay a much higher premium than your COBRA price, even if you chose a plan with higher cost sharing. On the other hand, you may qualify for advance-premium tax credits (premium subsidies) that reduce your net cost of coverage. It's worth exploring all your options before you make a final decision.

COBRA is often the better option - particularly if you’re retiring early through diligent saving through high lifetime income and therefore don’t qualify for taxpayer-funded premium subsidies. COBRA, however, has an expiration date. Usually, your period of coverage doesn't extend beyond 18 months. Thus, unless you retire at age 63 1/3, COBRA continuation won't bridge the full gap to age 65, when you're eligible to enroll in Medicare. Thus, absent other coverage options (such as jumping on a spouse's plan, if you're planning to retire and have your spouse continue to toil in the 9-to-5 world), you'll have to purchase a nongroup plan to cover the span between the end of COBRA and the beginning of Medicare coverage. Those nongroup premiums are not qualified for tax-free reimbursement (except in the situation below).

Unemployment

Some early retirees time their departures with corporate downsizings (also called layoffs or reductions in force). In this scenario, you volunteer to depart the company payroll and receive a separation package (which may include continuation of the company's standard premium subsidy during the first months of COBRA coverage – a nice financial bonus). Even with salary continuation, you may be eligible to collect unemployment benefits immediately.

When you're collecting unemployment benefits, you can reimburse your nongroup premiums tax-free. This provision provides tax-treatment parity between nongroup and COBRA premiums. But understand that unemployment benefits - and thus your window to reimburse nongroup premiums tax-free - typically expire long before the standard 18-month COBRA period. Your goal is to reduce the net price that you pay for coverage during the entire gap until you qualify for Medicare.

Deferred Reimbursement and the Shoebox Method

You face no deadline to reimburse qualified expenses tax-free, as you do with a Health FSA - a reimbursement plan that offers the same immediate tax benefits on deposits and withdrawals as does a Health Savings Account, but which has a defined plan year and claims-submission deadline.

You can defer reimbursement of qualified expenses from your Health Savings Account for years - even decades.

Example: You typically pay for qualified expenses with personal (after-tax funds) because you want to preserve your Health Savings Account balances to continue to grow tax-free. During two decades of ownership, you've deferred about $24,000 of reimbursement by paying smaller bills with your rewards credit card and not reimbursing yourself. If you retain those receipts, you can withdraw $24,000 at any time for any expense, then match the distribution to those receipts so that the transaction doesn't generate a tax liability.

You can leverage this provision to pay your nongroup premiums indirectly with tax-free withdrawals from your Health Savings Account. Here’s how: If your nongroup premium is $750 per month ($9,000 annually), you can pay almost three years of premiums with tax-free distributions from your Health Savings Account by pairing the distributions with receipts for qualified expenses that you didn't reimburse earlier. If you're at a 34.65% marginal tax rate (22% federal income, 5% state income, and 7.65% FICA), you save about $3,100 in taxes each year by paying premiums from your Health Savings Account rather than current taxable income.

Yes, that $3,100 of tax savings doesn’t represent new savings, but rather the tax benefit that you deferred. If you don’t use it now, it’s available in the future. That’s true. But at a time when you may be looking for funds to pay premiums to bridge a coverage gap, having access to Health Savings Account balances may be a lifeline – or at least a financial convenience.

Special thanks to my industry colleague Melissa Joy. We thought through this approach as we recorded a podcast last week.

Choose an HSA-qualified Nongroup Plan

When you shop for nongroup coverage, carefully consider enrolling in an HSA-qualified plan. You still can't reimburse your nongroup premiums tax-free – unless you’re collecting unemployment benefits. But you can build your balance to purchase future qualified expenses (including Medicare premiums) tax-free. And if you’re pairing receipts for deferred reimbursement against your Health Savings Account withdrawals for nongroup premiums, you can replenish your account balance - at least up to $5,150 in 2024 and $5,300 in 2025 - with new contributions. Your tax savings from your premiums and new contributions will fund more than 90% of your contribution (about $4,950 in 2025).

This simple strategy can help you manage your cost of coverage. HSA-qualified plans typically carry lower premiums. Thus, you pay less for coverage. As a bonus, you can replace funds that you withdraw via deferred reimbursement to pay your monthly premium. This action rebuilds your balance to withdraw funds tax-free to purchase future qualified expenses.

The Bottom Line

Health Savings Accounts are remarkably flexible vehicles. They are a financial ally to those who plan . . . and understand.

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HSA Monday Mythbuster is published every other week, alternating with HSA Question of the Week on Mondays. The content of this column is informational only. It is not intended, nor should the reader construe the content, as legal advice. Please consult your personal legal, tax, or financial counsel for information about how this information applies to you or your entity.