Money Talk: Health savings accounts offer big tax benefits. The trick is knowing when to use the funds

Dear Liz: My retirement account covers all my expenses, including medical. I also have $60,000 in a health savings account that is invested in a mutual fund. I’m struggling with how to use that. I could use it for all current medical costs, or just for unexpected big ones. Or I could keep the HSA as backup in hopes of leaving it to my heirs. All options seem to have advantages, and I’m stuck. Your thoughts?

Answer: HSAs offer a rare triple tax benefit: Contributions are deductible, the money grows tax deferred and withdrawals can be tax free if there are qualifying medical expenses.

If anyone other than your spouse inherits the HSA, however, it basically stops being an HSA. The account becomes taxable to the beneficiary in the year you die, which means the HSA loses one of its three tax breaks.

Inheriting an account that’s taxable is probably better than no inheritance at all. But generally it’s better to use the HSA yourself or leave it to a spouse and designate other money for heirs.

Trying to figure out the optimum rate of spending this money is obviously tricky. The longer you leave it alone, the more it can grow. But the longer you live without spending it, the greater the risk you’ll die without taking advantage of those tax-free withdrawals.

If you’re reluctant to tap the HSA, give yourself the option of “deathbed drawdown.” By keeping good records, you may be able to empty the account at the last minute and avoid taxes.

As you may know, you don’t have to incur a qualified medical expense in the same year you take an HSA withdrawal for the distribution to be tax free. As long as the expense is incurred after the HSA is established and before you die, it can justify a tax-free withdrawal, as long as the expense wasn’t reimbursed — paid by insurance or used for a previous HSA withdrawal. So keep careful records of all the medical expenses that you pay out of pocket. If you get a bad diagnosis or your health starts to deteriorate, you can use those receipts to justify a tax-free withdrawal.

Calculating Social Security benefits when a lengthy marriage ends

Dear Liz: I was married for 18 years before filing for a divorce. I am 71 and my husband is 76 and still working full time. He waited until he was 70 to collect his Social Security. Social Security told me to wait to file until he did to collect the maximum amount. I did, and then they told me that 50% of his benefit is less than my own benefit. Therefore I do not qualify to get benefits as a divorced spouse. I only get $1,200 a month. I made about $30,000 a year while he made six figures. I do not understand Social Security. I am barely getting by.

Answer: You got some bad information. Divorced spousal benefits, like spousal benefits for those who are still married, are based on the primary worker’s benefit at full retirement age. Spousal and divorced spousal benefits aren’t eligible for the delayed retirement credits that increase workers’ benefits when they delay applying for Social Security after full retirement age. In other words, you couldn’t benefit from your ex’s delayed start.

Like other retirement benefits, however, spousal and divorced spousal benefits are reduced if the applicant starts benefits before their own retirement age. If you applied at 65 and your full retirement age was 66, for example, you wouldn’t have qualified for the maximum divorced spousal benefit. Your own retirement benefit was reduced as well. If you’d been able to wait until after full retirement age to apply, your own benefit could have been increased by 8% for every year you waited until age 70.

It may seem odd that your benefit is still greater than what you could have received from his record, given the disparity in your incomes. But Social Security is designed to replace a bigger chunk of lower-paid workers’ incomes compared with higher-paid ones, on the assumption that lower-paid workers have a harder time saving for retirement. His income may have been four times larger than yours in recent years, but his Social Security benefit wouldn’t be four times bigger, or even twice as large.

What’s done is done, of course, but there may be a larger benefit in your future. If he dies before you do, then you would be eligible for a divorced spousal benefit, which would be 100% of his benefit (the one he’s getting when he dies, complete with delayed retirement credits and cost-of-living increases).

Liz Weston, Certified Financial Planner®, is a personal finance columnist. Questions may be sent to her at 3940 Laurel Canyon, No. 238, Studio City, CA 91604, or by using the “Contact” form at asklizweston.com.