Unless you are a CPA, financial planner, or tax nerd you probably don’t jump for joy when you think about taxes. Furthermore, almost no one likes having to plan for medical expenses. But a little bit of planning can go a long way in avoiding taxes and having real world results when paying for medical expenses. Recently I experienced this after needing a significant amount of dental work that insurance wouldn’t cover. After diving deeper into Health Savings Accounts and utilizing some of these tax-saving strategies myself, I wanted to share this information.
When it comes to tax advantaged saving, HSA’s are not always top of mind. 401(k)’s, Traditional IRA’s, and Roth IRA’s tend to draw more attention. I think this is a shame as HSA’s are what we like to call tax unicorns. The reason for this is additions to HSA account receive a federal tax deduction, grow tax free, and can be withdrawn tax free as long as the funds are used for qualified medical expenses. It’s almost too good to be true, never paying taxes on money that most Americans anticipate having to spend every year for medical expenses.
In addition to the tax benefits, employers sometimes match contributions to an HSA (up to certain dollar amount per year). In some instances, they will contribute a certain dollar amount regardless of your contributions as long as you are eligible and have an HSA opened. This is a great opportunity to get “free money” an employer is offering.
It’s important to note that HSA’s are similar to other tax advantaged accounts in that their annual contribution is limited and is perishable. Once you have filed your taxes for a given tax year, you can no longer make contributions to your HSA for that year. This indicates that whenever possible, we want to contribute to, or at least funnel expenses through the HSA. If you contribute more to the HSA compared to your expenses, the balance can be used in future years. This same feature is not available in other plans life Flexible Savings Accounts (FSA’s)2.
Ideally, we should plan on funding HSA’s with payroll deductions because of the tax benefits mentioned early. When HSA contributions are made with payroll deductions, not only do they provide a federal tax deduction, they also are not subject to FICA taxes. Not all HSA plans offer this additional layer of tax savings. However, most HSA’s are structured this way as it is usually the most advantageous for the employer as well3. This contribution method is similar to contributions made to a retirement plan as payments are deducted directly from your check and deposited into the HSA.
Alternatively, you can make contributions to your HSA directly from other sources. While slightly less advantageous, the federal tax deduction benefit is still available. Let’s say you have a $1,000 medical expense, $0 in your HSA, but you have the $1,000 set aside in your savings account. You can contribute that $1,000 to your HSA, pay for the medical expense from the HSA via an issued debit card, or “reimburse” yourself the funds and pay for the medical expense a separate way. The concept is to create the tax deduction by contributing to the HSA, and then documenting that you used the HSA money for a qualified medical expense.
What is the hard dollar benefit for utilizing an HSA in this way? Ultimately it depends on what tax bracket you fall into is for any given year. But for illustrative purposes, let’s assume you are a couple making $115,000 with no other deductions except the standard deduction of $24,400 (in 2019). Your adjusted gross income would place you in the 22% marginal tax bracket. Therefore, a $1,000 deduction would in theory save you $220 in federal income taxes.
For this same hypothetical situation, if a family was able to max fund an HSA for a given year, you would receive a 7,100 deduction2 (2020 annual contribution limit). Using the scenario illustrated above, that would equate to a roughly $1,562 reduction in federal taxes. If those funds were also contributed solely through payroll deductions, an additional $543 in FICA taxes could be avoided. Combine these two taxes savings and you have $2,105 in hard dollar tax savings. Furthermore, tax savings may exist on a state level as well. However, because Health Savings Accounts are a federally mandate program, states can choose to comply with the federal guidelines or make their own rules2.
Most HSA plans also include an investment component once the balance hits a certain dollar amount ($2,000 for example). Once reached, you can begin investing any dollars over the requirement. HSA account plans will often offer an investment lineup similar to a 401(k) that you can choose from. Please Note: investing in an HSA can add a layer of complexity that may be too much to manage at first. It’s always prudent to make these decisions with an additional level of caution. If you anticipate needing the funds within a relatively short time frame, it’s likely best to leave it in cash or use a low risk investment vehicle like a money market mutual fund.
HSA’s do add some extra work when filing your taxes. However, if you work with a CPA, the required forms are common. If you file your own taxes, most major tax prep software has easy to understand modules that help you file your HSA related forms correctly.
Hopefully by you now see why Health Savings Accounts can be so beneficial. You get the best of both worlds when it comes to taxes, it’s a great way to practice saving for medical expenses, and if you are able you can put your money to work through investments. Understandably, there are lots questions that come up when using an HSA that require detailed answers. For the most accurate and up to date information visit: https://www.irs.gov/publications/p969 This page can be daunting as it stores a lot material that may not be relevant to you. However, it offers the best information out there about HSA’s.
Andrew Froelich
CERTIFIED FINANCIAL PLANNER™
Sources:
1 https://www.optumbank.com/all-products/hsa/hsa-eligibility.html
2 https://www.irs.gov/publications/p969
3 https://www.hsaedge.com/2018/09/23/reduce-social-security-and-medicare-taxes-with-an-hsa/