Chapters

00:00 Introduction to HSA options for Mississippi PERS retirees

00:25 Two Major Options for HSA Accounts in Retirement

01:09 Option 1: Leave Funds in HSA to Grow and Pass to Heirs

03:08 Option 2: Take Distributions from HSA to Supplement Retirement Income

04:46 Case Study 1: PERS Early Retiree Liquidating HSA Account

07:25 Case Study 2: PERS Couple Using HSA to Cover Medical Expenses and Pass Remainder to Spouse

09:30 Case Study 3: Widowed PERS Retiree Passing HSA to Child

12:06 Action Items for PERS Retirees

13:13 Preview of Next Video and Offer for Services

14:26 Legal Disclaimer

Transcript

Hi everyone, I'm Ryan Earley, vested PERS member, financial planning firm owner, and host of the PERS Pro YouTube channel. Today, we are breaking down what Mississippi PERS retirees need to know about health savings accounts in retirement. Let's get started.

As you transition into retirement, deciding how to manage an HSA applies whether the account is in your name or your spouse's name. A PERS member with an HSA balance has two main options.

Option one is to keep the funds inside the HSA, allowing the account balance to remain invested, growing tax-free to cover significant medical expenses later in retirement, or pass to a surviving beneficiary. Option two is to systematically draw down the HSA to reimburse out-of-pocket medical costs, including Medicare premiums, or draw cash for general living expenses after age 65, subject to ordinary income tax. 

Let's examine the specific rules, pros, cons, and tax implications of both of these choices.  

First, let's look closely at option one: holding and growing your HSA assets throughout retirement and eventually passing the balance to your beneficiaries.

Under IRS Publication 969 and Internal Revenue Code Section 220, health spending accounts require zero minimum distributions during your lifetime. The estate rules depend heavily on who you name as your beneficiary on your HSA.  

Under Internal Revenue Code Section 220(f)(6) naming your spouse allows the HSA to automatically treat the surviving spouse as the owner upon your death, preserving full tax-free growth and opportunity for tax-free qualified withdrawals. 

However, under Internal Revenue Code Section 220(f)(8) naming a non-Spouse beneficiary, such as your child, triggers immediate taxes. The HSA terminates on the date of the owner's death and the entire fair market value of the HSA becomes ordinary taxable income to the non-spouse beneficiary in that tax year. 

The primary benefit of leaving funds in an HSA is compounding triple tax-free growth and a seamless spousal transfer upon death. On the downside, unlike taxable brokerage accounts, which we covered in video number 67, HSAs do not receive a step up in basis at the owner's death.

If passed to a non-spoused child, the full account value is taxed at ordinary federal and state income tax rates in that single tax year. As long as the owner is alive, both the IRS and the Mississippi Department of Revenue exempt all internal HSA dividends, interest, and capital gains from income taxes. Upon death, transfer to a spouse incurs zero federal or state taxes, while transferring to a non-spouse beneficiary forces full federal and Mississippi State income taxation in the year of death.

Now let's examine option two: actively taking distributions from your HSA to cover health expenses or to supplement your PERS retirement income.

Under IRS Publication 969, distributions used for qualified medical expenses are 100% tax-free at any age. Crucially for retirees, qualified expenses include Medicare Parts B, D, and Medicare Advantage Part C premiums, along with long-term care insurance premiums up to age-based IRS limits.  However, qualified expenses do not include Medigap or Medicare supplement insurance premiums.

If you take a non-qualified distribution before age 65, you face ordinary income taxes at both the federal and state level plus a severe 20% penalty from the IRS. However, once you turn 65, the 20% federal penalty disappears entirely.  Nonqualified distributions are simply taxed as ordinary income, making the HSA behave much like a traditional IRA after age 65.

The major benefit of withdrawing from an HSA is tax-free funding of medical costs and Medicare premiums, as well as the ability to retroactively reimburse yourself for past medical expenses incurred in prior years. It also helps to have an HSA fill retirement income gaps after age 65. 

The main con of withdrawing is the steep 20% penalty for non-qualified withdrawals prior to age 65 and the fact that non-qualified distributions after age 65 will increase your AGI.

Let's evaluate our first hypothetical case study, an early PERS retiree liquidating her HSA account completely over her initial retirement years. 

Ashley is a 46-year-old single retiree who earned $125,000 before retiring early with a $55,000 PERS pension. She decides to liquidate $10,000 annually from her $40,000 HSA balance over a period of four years. Each year, $6,000 covers qualified medical costs while $4,000 is drawn for non-qualified personal spending.  Ashley buys ACA Marketplace Health Insurance and plans to claim Social Security at age 67. 

Looking at Ashley's federal taxes, step one, we calculate her AGI by taking her $55,000 pension and adding her $4,000 non-qualified HSA withdrawal to arrive at a $59,000 AGI.  In step two, we determine her total deductions to simply be her $16,100 standard deduction. In step three, we take her AGI and subtract her standard deduction, yielding $42,900 in federal taxable income. In step four, we apply 10% and 12% federal income tax brackets to that taxable income, resulting in roughly $4,900 in ordinary income tax plus an $800 early withdrawal penalty bringing her total federal income tax liability to $5,700. 

For Mississippi State taxes, Ashley's PERS pension is 100% state tax exempt as a qualified retirement distribution. Her state adjusted gross income is only the $4,000 non-qualified HSA distribution. Step two applies $8,300 in combined Mississippi standard deduction and personal exemptions. Step three takes her AGI and subtracts her total deductions, resulting in a negative number so we round that to $0. Amazingly, even though Ashley took non-qualified distributions, she will pay $0 of state income taxes. 

Let's look at how this impacts Ashley's federal benefits. By keeping her non-qualified HSA withdrawal relatively small, Ashley's modified adjusted gross income stays at $59,000 preserving some of her Affordable Care Act Marketplace Health Insurance Premium Tax Credits. Because she is 46, Medicare, IRMAA and Social Security benefit rules do not apply.

Our second case study evaluates a married, high-income PERS couple using their HSA exclusively for qualified medical expenses while preserving the remaining balance for the surviving spouse.

Mark age 64 and Susan age 62 earned $500,000 prior to their retirement. Mark retires with a $120,000 PERS pension. Mark holds a $50,000 health savings account. They withdraw $15,000 from the HSA in their first year of retirement to pay medical co-pays. The remaining $35,000 remains invested to pass tax-free to Susan if Mark passes away.  Mark plans to claim Social Security at 65 and Susan at 70.

Reviewing Mark and Susan's federal taxes, step one, their AGI is $120,000, which comes from Mark's PERS pension. The $15,000 of qualified HSA withdrawals are 100% tax free. Step two, total deductions, is simply the $32,200 joint standard deduction.  Step three takes the AGI and subtracts the total deductions, yielding $87,800 in taxable income. Step four applies the 10% and 12% joint marginal income tax brackets to arrive at $10,040 in total federal income tax. 

On their Mississippi state return, Mark's $120,000 PERS pension and $15,000 of qualified HSA distributions are both 100% state tax exempt. This results in $0 Mississippi taxable income and $0 of state income tax. 

Let's look at how this impacts Mark and Susan's federal benefits.  Because qualified HSA distributions do not count toward MAGI, Mark and Susan maintain a $120,000 MAGI, completely avoiding Medicare IRMAA surcharges, and their social security benefits subject to taxation remains the same when Mark claims at age 65.

Our final case study evaluates a widowed PERS retiree who leaves his HSA untouched, illustrating the severe non-spouse beneficiary tax consequences for single or widowed retirees. 

David is a 67-year-old widower receiving $210,000 annually from his PERS pension and Social Security Survivor benefits. He holds a $150,000 health savings account and intends to leave the account to his daughter.  David is on Medicare Parts B, D and has a supplement policy. David plans to claim his own Social Security benefits at age 70. 

Looking at David's federal taxes, AGI in step one is determined to be $201,000, which is $150,000 of his PERS pension plus $51,000 of the taxable survivor benefits. Step two total deductions include his standard deduction and additional standard deduction for seniors netting $18,150. Step three takes AGI and subtracts total deductions, yielding taxable income of $182,850. Step four applies the 10%, 12%, 22%, and 24% single marginal tax brackets to arrive at $36,482 in total federal income taxes. 

It's important to note that David pays $0 in federal income taxes on the growth in his HSA. 

In Mississippi, both PERS pension and Social Security benefits are one hundred percent exempt from state income tax.  David's AGI, therefore, is $0, resulting in $0 Mississippi State income tax. David's $201,000 modified adjusted gross income places him in Tier 4 Medicare IRMAA bracket for a single filer. 

Crucially, if David had used his HSA to reimburse his Medicare premiums during his lifetime, he could have pulled tax-free cash out of the HSA without raising his IRMAA or taxes.

By holding $150,000 in the HSA until his death, his daughter will face a massive tax hit, losing up to $60,000 in federal and state income taxes in a single year if his daughter is in the highest federal tax bracket and resides in Mississippi. And on top of this, his daughter could lose valuable tax deductions and tax credits if the $150,000 of additional ordinary income pushes her and/or her spouse's income above critical phase out thresholds.

If you or your spouse hold a health savings account and are nearing PERS retirement, here are your action items for today.

1. Audit HSA beneficiary designations. Ensure your primary beneficiary is your spouse if you're married to guarantee tax-free continuation. If you plan to leave assets to a non-spouse heir, consider spending down your HSA dollars on qualified medical expenses during retirement instead of leaving a taxable HSA balance. 

2. Catalog out-of-pocket medical receipts. Gather and digitize past unreimbursed qualified medical receipts incurred since you established your HSA. You can reimburse yourself tax-free from your HSA at any point in retirement. 

3. Maximize your drawdowns after 65. Plan to use HSA tax-free distributions to pay Medicare Part B, Part D, and Medicare Advantage premiums after age 65. And consider withdrawing from your HSA to fund retirement income gaps after age 65 after exhausting other qualified retirement plan accounts like your 457(b) or your 403(b).

I hope this video helps Mississippi PERS members navigate their health savings account options and optimize their retirement health care planning. In our next video, we will answer the question: “What should a PERS retiree do with a 529 account?”, as we analyze Mississippi Affordable College Savings or MACS and Mississippi Prepaid Affordable College Tuition or MPACT accounts in retirement.  Please make sure you subscribe so you don't miss this and other videos in our new retirement series.

If you found this video helpful, you can thank me by hitting the thumbs up button and sharing it with other PERS members. And finally, if you are looking for a financial planner who specializes in helping PERS members plan for retirement, including building tax-efficient retirement plans utilizing health savings accounts, please visit our website at perspro.ms to learn more about how we help PERS members like you. 

Thank you for your valuable public service to the state of Mississippi. We'll see you next time.

Disclaimer, this video is for educational and informational purposes only. Neither the host nor this YouTube channel are officially affiliated with, endorsed by, or sponsored by the Public Employees Retirement System of Mississippi. Always consult a qualified professional for personal advice specific to your situation.