Health Savings Accounts, or HSAs, are arguably the most powerful single tax reduction tool available to individuals in the tax code.
These tremendous tax-saving accounts allow a triple tax benefit – and then some!
- Contributions are pre-tax.
- HSA assets grow tax-deferred.
- Withdrawals to pay qualified health expenses are tax-free.
Additionally, once you turn age 65, any unused funds become available penalty-free to supplement your retirement savings. You just pay income taxes on the withdrawals.
But you still get the benefit of tax-free withdrawals for qualified medical expenses, even in retirement.
And there are no income caps: There are no caps on income – Just about anyone covered under a qualified high deductible health plan is eligible to make pre-tax contributions.
For these reasons, fully-funding a health savings account should be one of your top financial priorities during your working years. Especially while you’re young, so the tax-deferred compounding has the most possible time to work its magic!
Tax Benefit # 1: Pre-Tax Contributions
HSA contributions directly reduce your federal income tax.
Contributing to an HSA allows you to set aside funds for future healthcare expenses before taxes are calculated, thus reducing your taxable income.
The higher your tax bracket, the more money you can save by contributing to a health savings account.
For example, If you’re in the 24% marginal federal income tax bracket, every $1,000 you contribute to an HSA saves you $240 in income taxes.
A family contributing the current (2023) maximum to an HSA in the 24% marginal income tax bracket can save up to $1,860. And if both spouses are over age 50, the family can save an additional $480 in income taxes by making the additional $1,000 allowable catch-up contributions each of them are entitled to by law.
If you’re in the 36% marginal income tax bracket, you can save even more: every $1,000 you can contribute to an HSA saves you $360 in income taxes. A family in the 36% marginal income tax bracket that contributes the current (2003) maximum to an HSA can save up to $2,790.
Do I have to Itemize to take advantage of HSA contribution deductions?
No… HSA contribution deductions are “above the line.”
That means you don’t have to itemize in order to take advantage of the federal deduction for HSA contributions. And unlike IRAs, HSAs have no maximum income level to qualify for tax deductible contributions: You can deduct contributions to HSAs at any income level.
State Income Tax Savings
If your state has an income tax, your savings are even greater.
That’s because you can deduct the amount of your contributions from your state income tax return.
Except in California and New Jersey, that is. California and New Jersey are the two states in the union that don’t allow taxpayers to deduct their individual HSA contributions on their state income tax returns. Want to change that? Contact your elected representatives in California and New Jersey, respectively, and tell them you want your state to come into parity with the 48 other states and let you deduct your individual HSA contributions on your state income tax returns.
For all other states, your HSA contributions can help you save money on your state taxes as well as federal.
To estimate how much you can save, multiply the amount of your HSA contributions by your marginal state income tax rate.
HSAs Reduce Social Security and Self-Employment Tax
It’s not just federal income taxes that are impacted. If you contribute to your HSA through a payroll deduction, those contributions are not subject to Social Security, Medicare, or unemployment taxes.
This is especially significant for self-employed individuals who are otherwise subject to a self-employment tax rate of 15.3%. By reducing your taxable income, you are effectively saving on multiple layers of taxation.
For example, suppose you’re married and file jointly with an income of $150,000 per year.
As of 2023, that puts you in the 22% federal income tax bracket.
For the purposes of this illustration, both of you are self-employed, so you are both subject to the self-employment tax of 15.3%.
Every dollar you can contribute to your HSA reduces your self-employment tax by 15.3 cents. So if you contribute the maximum $7,750 allowable pre-tax to the HSA, you save $1,185.75 in self-employment taxes.
That’s in addition to your income tax savings. By contributing the maximum allowable for a couple for 2023, you would save an additional $1,705.
So accounting for both potential income tax and self-employment tax savings, our notional couple earning $150,000 per year could realistically save a combined $2,890 in taxes just by taking full advantage of their allowable HSA contributions for the year.
And in 2024, HSA contribution limits are increasing – allowing you to save even more money in income and self-employment taxes.
HSA Savings for Employers
Employers, too, have an incentive to offer HSA-eligible high-deductible health plans, and encourage employees to take advantage of health savings accounts.
Employers can also contribute to employee HSAs. And when you do so, neither you nor your employee has to pay FICA/OASDI tax.
Every dollar your employee contributes to the HSA via payroll deduction saves you 7.665% in payroll taxes.
Over the course of the year, if your employee contributes the maximum allowable to their HSA via payroll deduction, bypassing payroll tax, you would save $590 per employee per year just in payroll taxes.
And another 7.665% is preserved for the employee.
Instead of going to the government, that 7.665 representing the employee’s half of their Social Security and Medicare taxes goes into their HSA, where it can compound tax-deferred, and is available tax–free to pay for any future healthcare expenses.
Furthermore, unlike FSAs, there’s no “use it or lose it” provision with HSAs. Employees can use that money when they need it.
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Tax Benefit #2: Tax-Deferred Growth
Assets in an HSA account grow tax-deferred –– as long as the money stays in the HSA.
That means there are no taxes on any interest, dividends, or capital gains generated within your HSA. Everything your money earns continues to compound on itself, unmolested by taxes.
Which means it grows faster.
Essentially, your money held within an HSA account receives the same favorable tax treatment as it compounds as your traditional IRA or 401(k) assets.
Suppose you are in a 22% tax bracket, and you have an initial balance of $100,000 each in identical investments earning 7% interest in two different accounts: a fully taxable investment, and a comparable tax-deferred investment such an HSA, IRA, or 401(k).
You leave them alone for 20 years. All you do is pay the income taxes owed on your interest income from the fully-taxable investment.
After over 20 years with no withdrawals, your taxable investment would grow to $289,571.
Your HSA investment, thanks to the power of tax deferral, would grow to an after-tax value of 386,968! That’s after a lump sum payment of 22% on your final withdrawal.
The Power of Tax Deferral
|Years of Compounding||HSA or Tax-Deferred Asset At 7%||Taxable Asset at 7%|
Self-Directed HSA Investing
Furthermore, if you wish, you can pursue higher returns on your money by investing your HSA mutual funds, stocks, investment products,and none of the growth is taxed as long as it remains in the account.
To do so, you need to choose a custodian for your HSA that supports self-directed investing.
Note: There are risks involved in self-directed investing. While you can potentially earn much more on your money than you could with a standard HSA, you can also lose money.
Make sure you have enough cash or other assets left in your HSA over time to at least cover any deductibles, copays, or co-insurance for medical expenses at any time.
You don’t want to take too much risk with your HSA assets and find yourself needing to put off or skip medical care you need because your investments lost money and you can’t cover your deductible!
HSA Tax Benefit #3: Tax-Free Withdrawals for Qualified Medical Expenses
Once you begin incurring medical expenses, you can make tax-free withdrawals from your HSA to pay them.
Note: It’s important to only use HSAs for qualified medical expenses until you reach age 65. Otherwise, the IRS assesses a 20% penalty for non-qualified withdrawals.
That’s in addition to any income tax due at the state and federal level.
But HSAs are tremendously beneficial when you use them as intended: For qualified medical and dental expenses, as defined in IRS Publication 502.
Let’s illustrate this benefit with a real-world example: the cost of a hip replacement.
Imagine you need a hip replacement, a surgery that can cost around $32,000 without insurance. If you pay cash for this operation and are in the 24% tax bracket, you would need to earn around $42,105 pre-tax to cover the surgery. However, if you use your HSA, you only need to save the actual cost of $32,000—no tax implications involved.
Your cost savings: $10,105.
That’s in addition to your tax savings when you made your HSA contributions, and in addition to your tax savings thanks to deferral of income and capital gains taxes on assets in the HSA.
Wait… Aren’t Medical and Dental Expenses Tax Deductible Anyway?
Yes, they are.
But only to an extent.
You can claim medical and dental expenses as itemized deductions on Schedule A of your individual income tax return.
But you still come out way ahead by using an HSA to pay healthcare bills instead of just deducting medical and dental expenses on Schedule A.
You can only claim itemized deductions on Schedule A if you don’t take the Standard Deduction, which is $27,770 for married couples filing jointly, and $13,850 for single taxpayers and married couples filing separately.
If you take the Standard Deduction, in other words, you can’t claim medical and dental expenses on your taxes at all. But you wouldn’t want to, if your standard deduction is more than all your itemized deductions combined.
The Schedule A Medical and Dental Deduction Threshold
Furthermore, without an HSA, you can only claim medical and dental expenses on Schedule A to the extent they exceed 10% of your adjusted gross income.
That means you will need to pay taxes on thousands of dollars of income below that 10% threshold that you wouldn’t have to pay had you used an HSA to cover all your medical expenses for the year.
You can’t take the Schedule A medical and dental expenses deduction and the standard deduction at the same time. It’s one or the other!
With an HSA, however, the tax-free treatment of HSA withdrawals isn’t limited to amounts exceeding 10% of your AGI. Instead, the HSA lets you take a tax benefit from the very first dollar you spend on medical and dental expenses for your family.
Let’s go back to our notional couple making $150,000 per year.
Let’s say this couple had $20,000 in out-of-pocket eligible medical expenses for the year.
Without an HSA, the best they could do would be to deduct $5,000 of those $20,000 in eligible medical expenses. That’s because of the threshold: They can only deduct amounts in excess of 10% of their adjusted gross income, or $15,000.
So the Medical and Dental Expenses Deduction only benefits them by about $847. That’s the 2023 annual contribution maximum of $3,850 by 22%, which is their marginal tax rate.
In contrast, by using an HSA, that same couple can reduce their tax bill by 22% of the entire amount of their bill.
In this case, the tax reduction benefit of using an HSA to pay for all $20,000 in medical expenses amounts to $4,400.
BONUS HSA TAX BENEFIT: HSAs As Supplemental Retirement Funds
Suppose you’ve been blessed with good health over your life, and didn’t need to tap much of your HSA assets. What then? Did you waste the tax benefit.
Not at all!
With HSAs, your money continues to compound, tax-deferred, for as long as you leave the money in the HSA.
Once you turn 65, the 20% penalty for non-qualified medical expenses goes away. From that point, you can make withdrawals as needed for any reason whatsoever. You just have to pay income taxes on the withdrawals you make – just like you would if you were withdrawing from a 401(k) or traditional IRA account.
But once you turn 65 and the 20% penalty vanishes, HSAs are actually better as retirement assets than 401(k)s or traditional 401(k)s.
Why? Because there are no required minimum distributions.
With 401(k)s and traditional IRAs, you must begin taking required minimum distributions (RMDs) at age 72 – and pay ordinary income taxes on those withdrawals whether you want to or not.
However, HSAs have no RMD requirements at all. You can let them compound as long as you want – and pass unused HSA assets on to your family.
Since you can name beneficiaries to your HSA, these unspent assets can pass to your family very quickly after your death.
Eligibility Criteria for HSA Contributions
To contribute to an HSA, you need to meet certain requirements:
- You must be enrolled in a high-deductible health plan (HDHP).
- You cannot be enrolled in Medicare, the VA, or similar coverage.
- You can’t be claimed as a dependent on someone else’s tax return.
The HSA Adult Child Loophole
The HSA adult child loophole is a somewhat lesser-known strategy that allows parents to pay for their adult children’s qualified medical expenses tax-free.
You can benefit from this loophole even if those children are not currently dependents or covered under their parents’ health plan.
It doesn’t work for every family. But in certain circumstances, it can save a lot in taxes.
Here’s how it works:
Who Can Use the HSA Adult Child Loophole?
The general rule is you can only use HSA funds tax-free for the account holder, the account holder’s spouse, and any dependents.
Once a child turns 19 (or 24 if they are a full-time student), they usually no longer qualify as a dependent for tax purposes.
But here’s the twist: The IRS defines “dependent” differently with respect to HSAs than they do for the more generally applicable income tax rules.
For HSA purposes, the IRS allows you to use HSA funds for your adult children who are not considered dependents for income tax purposes, provided they meet the following criteria:
- The adult child must be under the age of 26.
- The child must not have provided more than half of their own support during the year.
- The child must be a U.S. citizen, national, or resident.
How the HSA Adult Child Loophole Works
If you have an adult child who meets the IRS criteria above but is no longer a dependent on your tax return, you can still use your HSA to pay for their qualified medical expenses tax-free.
This can be beneficial if:
- The adult child has medical expenses but insufficient funds in their own HSA;
- The adult child is not covered under any health plan and incurs medical expenses, or;
- You, as the parent, have excess funds in your HSA that you would like to utilize for family medical expenses.
Note: The adult child does not need to be covered under the parent’s health plan for you to take advantage of this loophole.
Can I use an HSA when I’m enrolled in a healthsharing plan?
You can spend money in an HSA at any time, regardless of your coverage.
But you can only make pre-tax contributions if you are currently enrolled in a qualified high-deductible plan that provides ten minimum essential coverages (MEC) as defined by federal law.
Currently, at least one health share plan is structured as a MEC plan: HSA SECURE.
If you’re a member of this plan, you can qualify to make pre-tax contributions to your HSA.
However, you must have verifiable self-employment or own a business to enroll in HSA SECURE.
Note: While traditional health insurance premiums are tax-deductible, healthsharing contributions are not.
However, because healthsharing routinely saves as much as 50% off the cost of an unsubsidized traditional health insurance premium, healthsharing plan members frequently come out way ahead, even without the tax deduction for contributions.
To enroll, or to learn more about combining health.
HSA Adult Child Loophole Tips
- Document everything. Keep thorough records of all medical expenses paid for an adult child through your HSA to substantiate the withdrawals as qualified medical expenses.
- Mind your contribution limits: Using HSA funds for an adult child doesn’t increase the annual HSA contribution limit, which is set by the IRS and updated every year to keep up with the cost of living.
Utilizing the HSA adult child loophole can be a tax-efficient way to assist adult children with their medical expenses. However, as with all tax strategies, it’s advisable to consult with a tax professional to apply the law and regulations to your own specific circumstances.
2024 HSA Contribution Limits
Effective January 1st, 2024, the annual limit on HSA contributions for self-only coverage is increasing by 7.8% to $4,150, up from $3,850 in 2023.For those with family coverage, the HSA contribution limit is increasing by 7.1% to $8,300, up from the $7,750 limit in 2023.
Those aged 50 or over can make an additional contribution of $1,000 for both years.
The higher limit reflects the unusually high inflation rates that prevailed in late 2022 and early 2023.
These higher limits present an excellent opportunity to save even more towards potential medical expenses in the future.
When is the HSA Contribution Deadline?
The HSA contribution deadline is the same as it is for IRAS:
- You have until April 15th, 2024 to make HSA contributions for tax year 2023.
- You have until April 15th 2025 to make contributions for tax year 2024.
What happens if I withdraw HSA funds for non-qualified expenses?
Withdrawals for non-qualified expenses are subject to income tax and a 20% penalty unless you are 65 or older, deceased, or disabled.
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What to Do Now
The Health Savings Account is not merely a tool for managing healthcare expenses; it’s a powerful vehicle for wealth accumulation and tax optimization.
With pre-tax contributions, tax-deferred growth, and tax-free withdrawals for qualified medical expenses, an HSA provides a triple-tax advantage that is hard to beat. Don’t overlook this vital resource in your financial planning arsenal.
To navigate the complexities and to ensure you’re maximizing your potential tax benefits, contact a Personal Benefits Manager today for more information or to enroll in a qualifying high deductible health plan, which will enable you and/or your employer to make tax-advantaged contributions to a health savings account.
Click here to make an appointment for a FREE consultation with a Personal Benefits Manager.
Remember, when it comes to your financial health, every dollar and every tax break counts.
Here are few blogs for further reading: How To Switch to an HSA-Compatible Plan (And Why You Should Do It) | Higher 2024 HSA Contribution Limits Allow You to Save Even More on Taxes | Can I Use an HSA to Pay for Counseling or Therapy?