Health Savings Accounts: A Triple Tax Advantage

Introduction

Health Savings Accounts (HSAs) have emerged as a versatile financial planning tool offering significant tax benefits overlooked by most people. By combining pre-tax contributions, tax-free withdrawals for qualified medical expenses, and the potential for tax-deferred growth, HSAs provide a powerful strategy for individuals to mitigate the impact of healthcare costs and accumulate wealth for the future.

HSAs are one of the most valuable and overlooked tax strategy vehicles available to many. This article delves into the intricacies of HSAs, exploring their eligibility requirements, contribution limits, and the specific circumstances under which these tax advantages can be maximized.

Health Savings Accounts Overview

An HSA is a tax-advantaged savings account specifically designed to help individuals save for qualified medical expenses. To be eligible for an HSA, an individual must be enrolled in a High Deductible Health Plan (HDHP), not be covered by Medicare, and cannot be claimed as a dependent on another taxpayer’s return.

As the name suggests, a qualifying high deductible health plan must meet certain minimum deductible and out-of-pocket cost limits. However, other qualifying rules apply besides the deductible and out-of-pocket limits. You should confirm with your employer or insurance carrier directly if your plan is a qualifying high deductible health plan. 

Advantage # 1: Tax-Deductible Contributions

Contributions to an HSA are made on a pre-tax basis, reducing an individual's taxable income. Both employees and employers can contribute to an HSA, up to specified annual limits ($4,150/$8,300 for individual/family coverage in 2024[1]).

The significant tax advantage lies in the fact that HSA contributions are deductible for federal income tax purposes and may also be deductible for state income taxes. Additionally, if contributions are made through payroll at your work, these contributions are exempt from payroll taxes such as Social Security and Medicare.

Let’s say you are a family covered by a high deductible health plan, have a 5% state tax rate, and are in the highest federal tax bracket of 37%. Also, payroll taxes are 7.65%. A maximum contribution of $8,300 yields tax savings of $4,121 – or almost 50%!

Advantage # 2: Tax-Free Withdrawals

Funds withdrawn from an HSA for qualified medical expenses are entirely tax-free. This represents a substantial tax savings compared to traditional healthcare payment methods. Qualified medical expenses include any amounts paid for medical care by the HSA owner and the HSA owner’s spouse and any dependent[2]. The term “medical care” is also broad, and includes any amount paid[3]:

1. For the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body

2. For transportation primarily for and essential to medical care

3. For qualified long-term care services, or

4. For any long-term care insurance contract.

Many health insurance premiums are not a qualifying expense for tax-free withdrawal from an HSA. However, health premiums paid while one is on COBRA continuation coverage, any health plan during a period on which someone is receiving unemployment compensation, or Medicare insurance policies all qualify[4].

It is worth highlighting that even those that do not expect significant healthcare expenses would benefit, as HSA dollars in the future can be used to pay for long-term care and Medicare insurance premiums.

Advantage # 3: Tax-Deferred (or Free!) Growth Potential

Unlike traditional Flexible Spending Accounts (FSAs), HSA funds can be invested in a variety of investment options, such as stocks, bonds, and mutual funds. This allows for the potential of tax-deferred growth over time.

If we assume that you can save the family maximum of $8,300/year and earn 8% per year for twenty years prior to retirement - you will have accumulated almost $380,000 by the time you retire. Your contributions of $166,000 are less than half of the accumulated amount! The difference of about $220,000 is tax-deferred, or tax-free if they can be withdrawn for medical expenses!

Other Unique HSA Features that Make Them A “No Brainer”

The combination of the three advantages noted above are unique only to Health Savings Accounts. However, several other characteristics truly set apart the HSA in a league of its own:

• Portability: HSAs are owned by the individual and remain with them regardless of employment or health insurance changes. This portability ensures continued access to the account and its funds.

  Unlike Flexible Spending Accounts, HSAs are not a “use it or lose it” account. Moreover, if funds are accumulated through payroll and you subsequently leave your employer, you keep the funds. If you stop being covered under a high deductible health plan, you cannot further contribute to the HSA but can continue to keep it in place and use it for qualifying health expenses.

• Long-Term Savings: There is no time limit on using HSA funds to reimburse qualified medical expenses. This flexibility provides individuals with the option to save for future healthcare costs.

  Generally, if cash flow allows, many individuals would benefit greatly by maximizing their contributions to their HSA, investing the account for long-term growth, and separately covering any out-of-pocket medical costs from other cash. Be sure to save proper documentation of any out-of-pocket expenses paid!

  Let’s assume that an individual has accumulated an HSA balance of $380,000 in the twenty years prior to retirement and has documented unreimbursed health expenses of $40,000 over the same period. That person can withdraw $40,000 tax-free from their health savings account on the first day of retirement. The remaining $340,000 can be used to fund future health expenses or premiums for Medicare or long-term care insurance.

• Penalty-Free Distributions After Age 65: Here’s the real kicker with HSAs. There is very little risk to “over funding” the account. Once an individual reaches age 65 (Medicare age), they can withdraw funds from their HSA for any purpose without incurring a penalty[5]! However, non-medical withdrawals will be subject to income tax. In short, after age 65, you have an account that is taxed like a pre-tax IRA or your 401(k) but can be used tax-free for medical costs.

Conclusion

HSAs offer a compelling combination of tax benefits and flexibility, making them a valuable component of comprehensive financial planning. By understanding the eligibility requirements, contribution limits, and qualified medical expenses, individuals can effectively harness the power of HSAs to reduce their tax burden, accumulate wealth for retirement, and address potential healthcare costs.

 

This article provides general information and should not be construed as tax or financial advice. It is essential to consult with a qualified tax professional or financial advisor to assess your circumstances and determine the optimal strategies for utilizing an HSA.

Investment advice, financial planning, and retirement plan services are provided by Prosperity Planning, Inc., an SEC registered investment advisor. The information contained herein, including but not limited to research, market valuations, calculations, estimates and other material obtained from these sources are believed to be reliable. However, Prosperity Planning, Inc. does not warrant its accuracy or completeness. The information contained herein has been prepared solely for informational purposes and is not an offer to buy or sell or a solicitation of an offer to buy or sell any security or to participate in any trading strategy. If an offer of securities is made, it will be under a definitive investment management agreement prepared on behalf of Prosperity which contains material information not contained herein and which supersedes this information in its entirety. Any investment involves significant risk, including a complete loss of capital and conflicts of interest. The applicable definitive investment management agreement and Form ADV Part 2A will contain a more thorough discussion of risk and conflict, which should be carefully reviewed before making any investment decision.

[1] IRS Revenue Procedure 2023-23

[2] I.R.C. Sec. 223(d)(2).

[3] I.R.C. Sec. 213(d)(1).

[4] I.R.C. Sec. 223(d)(2)(C).

[5] I.R.C. 223(f)(4)(C).