Probably one of the most overlooked employee benefits that has both tremendous tax advantages and the potential to act as a retirement planning strategy is the HSA or Health Savings Account. Not only are contributions tax-deductible, but withdrawals are tax-free provided they are used for qualified medical expenses. But wait, there’s more: earnings on these funds can be tax-free and there’s no “use it or lose it” provision, allowing you to build up an additional source of funds that can be used for healthcare expenses in retirement or as a source of income in your later years. Sounds pretty good, right? So, let’s start with the basics.
What Is an HSA Anyway?
A lot of people think that FSAs or Flexible Spending Accounts and HSAs (Health Savings Accounts) are the same — and while they share some characteristics, they are in fact quite different. Both are funded with pre-tax contributions, and funds can be withdrawn tax-free to cover qualified medical expenses, but that’s where the similarities end. Unlike FSAs, HSAs are only available in conjunction with an HDHP or High Deductible Health Plan. In order to qualify, the deductible on the healthcare plan must be at least $1,300 for single coverage and $2,600 for family coverage. Employees and/or employers make tax-free contributions to the HSA. Yep! You read that right: employers can match your HSA contributions, just as they would make matching contributions to your 401(k) plan.
HSAs offer investment options that differ from plan to plan, but most often can be invested in bank-type instruments or mutual funds. Contribution limits are usually adjusted annually and, unlike IRAs or other tax-deferred accounts, there are no income threshold limits. This feature makes them especially attractive for high income earners, who have maxed out on their retirement accounts and are looking for ways to cut their tax bill. For 2017, the maximum HSA contribution an individual can make is $3,400 (or up to $4,400 for participants between the ages of 55 and 65) and $6,750 for family coverage (or up to $7,750 if one spouse is 55 or over; if both spouses are 55 or over, the maximum is $8,750). For example, if you are a single taxpayer, age 40, and have maxed out on your 401(k) contributions at $18,000, you could sock away up to an additional $3,400 into an HSA, and reduce your taxable income by $21,400! Or if you are single, age 55 or over, and want to max out using the catch-up provision for both the 401(k) and HSA, you could drive down your taxable income by $28,400.
How Does It Work?
First step: you must be enrolled in a qualified HDHP (High Deductible Health Plan). This is extremely important. Just because you have a health insurance plan with a high deductible doesn’t necessarily means that it meets the requirements of a qualified HDHP. So be sure to check with your insurance company or employer to confirm your plan’s status. Next, decide how much you want to contribute. As mentioned above, you can fund your HSA up to the annual maximums, and because it’s tax-deductible, your income tax will be reduced as well. Also, keep in mind that your health insurance premiums will be reduced as well — so it’s a real win/win situation!
Now, here’s how this all comes together. Let’s say you are single, age 52, have a $2,500 HDHP, and have funded the maximum of $4,400 to your HSA. You require some tests and procedures that amount to roughly $1,500 in expenses. That $1,500 can be withdrawn from your HSA — tax-free — to cover all of those medical expenses and the balance ($2,900) remains in the account and continues to grow tax-free! And here is where the really good news comes in: unlike FSAs, there is no “use it or lose it” provision, so any remaining balance rolls over and can be used in the following year — or years. Making additional tax-deductible contributions to this account can be a powerful planning tool for your long-term planning arsenal. The proceeds can be used for most health-related expenses, such as medical and hospital visits, prescriptions, psychiatric care, dental treatments, and even paying for long-term care premiums, just to name a few. For a deeper dive into qualified HSA expenses, check this IRS site for more details.
So just to recap, here’s a summary of the trifecta advantage of Health Savings Accounts:
- Contributions are pre-tax, effectively reducing your taxable income.
- Earnings and withdrawals are tax-free provided they are for qualified medical expenses.
- There is no “use it or lose it” provision, allowing the funds to remain the account indefinitely.
If you’re looking for ways to cut your tax bill now and to reduce your taxable income in the future, an HSA could be your new best friend!