As we enter annual benefits enrollment season, now is a great time to be reminded of the triple-tax benefits of Health Savings Accounts (HSA).
To qualify for an HSA, you must be enrolled in a “high-deductible” health insurance plan. This is an important consideration, as some people may not be comfortable with higher annual deductibles, as the out-of-pocket costs may be more than they can afford.
HSAs were established under the Medicare Modernization Act of 2003. According to the IRS, those are plans in 2022 “with an annual deductible that is not less than $1,400 for self-only coverage or $2,800 for family coverage, and the annual out-of-pocket expenses (deductibles, co-payments and other amounts, but not premiums) do not exceed $7,050 for self-only coverage or $14,100 for family coverage.” If you can handle the higher deductibles, HSAs provide triple tax advantages by allowing you to save for current health expenses and/or future health expenses.
Triple Tax Advantages
The first tax advantage is that contributions to an HSA are pre-tax, as they are either withheld from your paycheck or deductible in calculating your adjusted gross income. This allows you to lower your taxable income in the year of contributions.
The second tax benefit is the ability to withdraw funds tax-free if used for qualified medical expenses. Qualified expenses include most services provided by licensed health providers, as well as diagnostic devices and prescriptions. If you’re familiar with Flexible Spending Accounts (FSA), this is similar in that you can use pre-tax dollars for current year health expenses (co-pays, deductibles, etc.)
The HSA is slightly better than the FSA in that you do not need to know before the year starts how much to save, as you can carry-over all unused HSA dollars. Unlike FSAs, which have a maximum year-to-year carryover of $500, HSAs have no limit on carryovers or when the funds may be used.
The third tax benefit is tax-free earnings. At a minimum, your HSA should provide a cash account that pays some interest on your balance. Many plans have an investment feature where you can invest for the long-term in a diversified portfolio of stock and bond mutual funds.
There is also a strategy to maximize the account’s tax-free benefits. You can invest the money for long-term appreciation, letting it grow tax-free, rather than spending it on current health care needs. By doing this, the HSA resembles a Roth IRA in that it grows tax-free, but you also get the benefit of a current tax deduction. By growing the HSA as long as possible, you can hedge against the risk of rising health care costs.
HSAs do have contribution limits. For the upcoming 2022 tax year, an individual may contribute up to $3,650; $7,300 for a family. People over 55 may add another $1,000 per year as a catch-up contribution, so the over 55 limits are $4,650 for self-only and $8,300 for a family.
Health care costs continue to rise. According to the Fidelity Retiree Health Care Cost Estimate, an average retired couple age 65 in 2021 may need approximately $300,000 saved (after tax) to cover health care expenses in retirement. Of course, the amount you’ll need will depend on when and where you retire, how healthy you are, and how long you live.
You can also make a one-time transfer from an IRA. Individuals may make a tax-free rollover from an IRA to an HSA once in their lifetime. The rollover is limited to the maximum allowable contribution for the year, minus any amount already contributed.
Before age 65, account owners face a 20% penalty for withdrawals for non-qualified expenses. Starting at age 65, account owners may take penalty-free distributions for any reason. However, to be tax-free, withdrawals must be for qualified medical expenses.
So, for some people, a strategy to consider would be to fund your projected retirement health care costs in an HSA. This could provide you with the peace of mind of having your health expenses covered by tax-free dollars. If your other retirement dollars are depleted, you can still access these dollars for your retirement by taking taxable distributions.
As Health Savings Accounts have become more popular in recent years, there are other scenarios to consider as you plan for your retirement health care costs. Here are some considerations:
Will my employer provide an incentive for me to contribute to an HSA?
Many companies offer an incentive to go to a high-deductible health insurance plan with an HSA. Some companies will match the deductible difference. So, if you go from a $1,000 to $1,500 deductible, the employer may put $500 into the HSA. Many large employers can provide even bigger benefits ($1,000-$2,000). You’ll need to check with your employer for specific details.
Can someone open an HSA outside of their employer or must it be through payroll deduction?
Yes, you can open an HSA even if your employer does not offer one. You can only make current-year contributions if you are covered by an HSA-qualified health plan (high-deductible plan). Yes, qualified withdrawals remain tax-free.
Should I pay medical expenses out-of-pocket?
You can pay out-of-pocket and get reimbursed later. There is no deadline to reimburse yourself for a medical expense paid out-of-pocket. Keep your receipts!
Can you use your own HSA to pay for expenses for someone else or a dependent?
Yes, it can be used to pay for your spouse or dependent medical expenses, as long as the expenses were not otherwise reimbursed.
What are the investment options?
That is plan specific. Each plan offers a custom fund line-up similar to a 401(k). Most plans require a minimum balance ($1,000-$3,000) in cash and the ability to invest the excess. If you run into a plan without an investment option, contact your employer to request an upgrade to the plan. Without the investment piece, many of the best benefits disappear.
Can I contribute to an HSA if I am beyond age 65 and on Medicare?
No, you cannot contribute to HSAs after you are on Medicare. For folks that work beyond age 65, they might want to defer applying for Medicare so they can continue to contribute to their HSAs.
What happens to your HSA if the account owner dies?
For non-spouse beneficiaries, the funds are distributed and taxed as income to the beneficiary at fair market value. Beneficiaries can use the funds to pay medical expenses for the deceased up to 12 months after death. For surviving spouses, the account can transfer with no tax consequences as if it was their own.
If you’re looking to incorporate more strategic options into your financial plan or have questions about what steps may be right for you, we’re always open to having a conversation at Domani Wealth. Please give us a call at 855-855-5455, email [email protected], or get in touch with one of our team members.