!!!Editor’s Note!!! If you’re like most people, your eyes glaze over and you almost instantaneously fall asleep as soon as anyone begins discussing anything as boring as health savings accounts! We don’t blame you. Saving for healthcare costs isn’t something most people want to think about, but the reality is that everyone is going to have health care costs, and health savings accounts provide significant tax advantages that will save you money so that you can do more of the things you enjoy today! So read on if you like reducing your taxes!
Health savings accounts (HSAs) have been around for nearly two decades. First introduced in 2004, health savings accounts provide a way for Americans to temper the bite of significant health care costs by creating a tax advantaged way to save for these expenses.
For perspective, in 2021 U.S. health care spending reached $4.3 trillion dollars which was just over $12,900 per person. While many individuals are healthy today, the unavoidable truth is that most individuals will need significant health care at some point in their lives. Savings for these costs is important, and thanks to the health savings accounts, saving can provide significant tax advantages.
Eligibility for HSA Account Contributions:
Health savings accounts are tax advantaged accounts designed to allow individuals to save for health care costs. Unlike flexible spending accounts, HSA accounts are owned by the individual (i.e. not lost if individual switches jobs) and balances within HSA accounts accumulate year to year. Additionally depending on the provider, the amounts in HSA accounts can typically be invested to allow for growth throughout the years.
Since HSAs are tax advantaged accounts, there are specific rules that must be followed.
First, individuals can only contribute to an HSA account if they are covered by a high deductible health plan (HDHP). Since the deductible is the portion the patient is responsible for paying before insurance kicks in, a “high deductible” health plan may sound concerning to many individuals. In reality, it is simply a term given to a specific class of health care plans that have a deductible falling within a specific range. Certain HDHPs even provide preventive care before the deductible is met.
To qualify as a HDHP, the deductible must fall within the following ranges.
Key Takeaway:
High Deductible Health Plans have minimum (but reasonable) thresholds for deductibles and maximum out-of-pocket limits.
Second, since being covered by a HDHP is a requirement for contributing to an HSA account, having additional non-HDHP coverage through a spouse’s plan or Medicare would eliminate an individual’s ability to contribute to an HSA account.
Third, individuals who are still claimed as dependents on someone else’s tax return, are not eligible to contribute to their own HSA account.
An important point to note is that HSAs do not have income limits. Individuals who are otherwise eligible to contribute to an HSA account can do so regardless of their income level.
Contributing to HSA Accounts:
Those who are eligible to contribute to an HSA account, can make annual contributions. Just like tax advantaged retirement accounts, the IRS has limits on the amount an individual can contribute to an HSA account each year.
Individuals who are age 55 or older as of the end of the tax year are allowed a catch-up contribution of an additional $1,000 annually.
Those who are not eligible to contribute to an HSA for the entire year (i.e. were not covered by a HDHP all year, were a dependent, etc.) have to prorate their maximum contribution based on the number of months they were eligible to contribute to an HSA account.
There is one exception to the proration requirement for individuals who became eligible during the year. If an individual was not eligible for the entire year, but was eligible on the first day of the last month of the year, that individual can make a full contribution assuming they remain eligible through the entire following tax year.
In other words, most individuals covered by an HDHP on December 1st of the current year will be allowed to make a full HSA contribution for the current year as long as they remain on an HDHP for the entire following year.
Key Takeaway:
HSA accounts have annual contribution limits that are impacted by age and whether the account owner met the contribution eligibility requirements for the entire year.
Tax Benefits of HSA Accounts:
Of all the tax advantaged savings accounts (i.e. Roth and Traditional 401ks, IRAs, etc.), HSAs are the most tax efficient. This is because they provide three tax advantages.
- First, the taxpayer receives an upfront tax deduction (or a reduction in wages if made through payroll) for contributions to the HSA account.
- Second, all growth within the account is untaxed.
- Third, all distributions are tax-free if they are used for qualifying health care costs.
Other tax advantaged accounts often have two of these benefits, but not all three. For example, a Roth IRA grows tax-free and distributions are tax-free, but there is no upfront deduction for contributions. A traditional IRA provides a deduction for contributions and tax deferred growth, but withdrawals are taxable. Health savings accounts are unique in that they provide all three tax benefits!
Key Takeaway:
HSAs are the most tax efficient accounts because they provide a TRIPLE BENEFIT! They provide a tax deduction when the contribution is made, tax-free growth over time, and tax-free distributions for qualified medical expenses.
Value of HSA vs Non-HSA Example:
For perspective, let’s walk through an example of two families. Both families have $7,750 in cash available to invest annually. The first family chooses to take full advantage of their HSA account by making the maximum annual contribution to their HSA while the second family simply invests their funds in a non-HSA, taxable investment account. Each family makes their contributions at the beginning of each year.
Over the course of 20 years, assuming a 7% rate of return the family who invested within the HSA account would have a total of $339,955 in their HSA account. Assuming they use those funds for health care costs during their lifetime, those funds will be completely tax free to them.
Now let’s consider the second family who did not utilize the HSA account. If we assume they are in the top federal tax bracket of 37% and a state tax bracket of 5%, the fact that they chose not to contribute to their HSA will result in lost tax savings of $3,255 annually ($7,750 x 42%). As a result, they only have $4,495 of their original $7,750 left over to invest after paying taxes.
If they invest that $4,495 in a non-HSA account for the same 20-year period and achieve the same 7% rate of return, their non-HSA account will be worth $197,174 at the end of the 20-year period.
However, since the balance is not in an HSA account, they will have to pay tax on any capital gains that occurred during that period. Twenty years of investing $4,495 means they have contributed a total of $89,900 to the account which leaves the remaining $107,274 to be taxed as a capital gain.
Given this family was in the top ordinary income tax bracket, they would also be in the top capital gains tax bracket of 20% and would subject to the 3.8% net investment income tax. We’ll also assume the same 5% state tax rate. Altogether they would pay a 28.8% capital gains tax rate which would result in capital gain taxes in excess of $30,800. As a result, after taxes they would have approximately $166,000 left over which is $173,000 less than the family that utilized the HSA.
Since there are a lot of numbers in the above example, we’ve included them in the following table to demonstrate the calculation.
The growth of the HSA account in comparison to the after-tax growth of the non-HSA account over the 20-year period is clear to see in the following graph.
Given HSA accounts provide significant tax advantages over non-tax advantaged investment accounts which can lead to six-figure savings, it is important to ensure eligible individuals take advantage of the opportunities HSA accounts provide.
However, since tax-free withdrawals are only allowed if the funds are used for qualifying health care expenses, the next questions that need to be considered are the types of expenses that qualify for tax-free distributions and whether there will be enough expenses to allow for the full HSA account to be distributed tax-free in the future.
Key Takeaway:
The tax advantages provided by health savings accounts can lead to substantially more wealth accumulation over time.
Qualifying Medical Expenses:
Qualifying medical care expenses that are eligible for tax-free HSA distributions are generally the same expenses that would qualify for the medical and dental expenses deduction which is laid out in IRS Publication 502. They include amounts paid for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body.
IRS Publication 502 provides a detailed list of eligible expenses. In conjunction with the list in Publication 502, the following are a few important points to consider:
- Qualified medical care expenses include expenses incurred by the HSA owner, their spouse, and their dependents.
- The qualified medical care expenses must be incurred after the HSA account was established.
- Long-term care expenses including residential nursing home care and in-home care qualify as eligible expenses to the extent they are medically necessary and are not covered by insurance. This includes the costs of meals and lodging if the primary purpose of being in the nursing home is to get medical care.
- Insurance premiums are NOT qualified expenses unless they are for one of the following:
a. Long-term care insurance (subject to certain limits).
b. Health care continuation coverage (such as coverage under COBRA).
c. Health care coverage while receiving unemployment compensation under federal or state law.
d. Medicare and other health care coverage for those age 65 or older (other than premiums for a Medicare supplemental policy, such as Medigap).
Given the substantial cost of health care especially as individuals age, it is becoming increasingly important to have funds set aside and saved to cover these costs in retirement. Fidelity’s Retiree Health Care Cost Estimate projects that the average couple age 65 in 2022 will spend $315,000 on health care during their retirement , and this estimate excludes any long-term care costs.
If the expense of long-term care is included in the estimate, the total cost for many retired couples has the potential to exceed the $315,000 estimate substantially. Accordingly, the risk of overfunding an HSA account and not having enough qualified expenses to distribute the funds tax-free during life is low in most cases.
Key Takeaway:
A retired couple is expected to have approximately $315,000 of qualifying medical costs during the course of their retirement (excluding long-term care).
What If Funds Are Used for Non-Qualified Expenses?
While most individuals will have sufficient qualified medical expenses during their lifetime to fully utilize their HSA balances tax-free, it is still important to consider how non-qualified distributions are treated.
If HSA funds are distributed but are not used to pay for qualifying medical expenses, the distribution is taxable as ordinary income and also subject to a 20% additional tax (i.e. penalty). The 20% additional tax does not apply after an individual reaches age 65, becomes disabled, or dies.
Given the regular tax and significant 20% additional tax on non-qualified distributions, it is best to only use HSA accounts to cover qualified expenses. However, if an individual does overfund their HSA account and needs to withdraw a portion of the balance for reasons other than paying qualified medical expenses, it is best to do so after reaching age 65 when the additional 20% tax no longer applies.
Key Takeaway:
It is very costly to distribute HSA funds without qualified medical expenses – especially for those who do not qualify for an exception to the 20% additional tax.
Strategy To Maximize HSA Benefits:
What is the best way to maximize the tax benefits provided by HSA accounts? Aside from the obvious answer to max out HSA contributions annually, there is a way to significantly increase the value of your HSA account that typically is overlooked.
One of the biggest tax benefits of an HSA account is the tax-free growth over time. However most individuals use their HSA annually to cover medical expenses as they are incurred. This removes those funds from their HSA account and keeps those funds from experiencing tax-free growth in the future.
To understand the best way to maximize HSA accounts, it is important to understand that the distributions from HSA accounts to cover medical expenses do not have to occur in the same year the medical expenses are incurred.
Instead, the distributions from HSA accounts can be made years after the qualified medical expenses were incurred. The key to this strategy is that the medical expenses still have to be qualified – which includes occurring after the HSA was established – and the individual needs to be able to substantiate the expenses.
To implement this approach, an individual would pay their qualified medical costs using non-HSA funds and would save their receipts and related documentation. Then at any given time in the future, they could withdraw an amount from their HSA account that is equal to or less than their documented qualified medical expenses.
This allows the funds in the HSA to continue growing tax free without losing the ability to withdraw the funds tax-free in the future.
The strategy of saving receipts can create substantial value by allowing the HSA account to compound tax-free for years and even decades; however, for those who choose to implement this strategy, it’s important to consider the risk that the HSA owner passes away before withdrawing all the funds.
Key Takeaway:
To maximize tax-free growth, it is advantageous to pay for qualified medical expenses using non-HSA funds, save receipts for future reimbursement, and let the HSA grow tax-free for years.
HSA Balances at Death:
Like most other investment accounts, HSA accounts allow the owner to name a beneficiary on the account. The resulting treatment depends on the type of beneficiary named:
Spouse: If the beneficiary is the owner’s spouse, then the spouse can take over the HSA account and is allowed to use it to cover their own qualified medical expenses during their lifetime.
Non-Spouse: If the beneficiary is not the owner’s spouse, the entire account will be distributed to the beneficiary and will be treated as taxable income to the beneficiary as of the date of death. If there were any medical expenses incurred by the account owner prior to death that were subsequently paid by the beneficiary within one year after the account owner’s death, the beneficiary’s taxable portion of the HSA distribution is reduced by the amount of the medical costs paid.
For a large HSA account, a full distribution to the beneficiary in a single year can result in a significant amount of taxable income. Considering the account owner’s children (who would be the likely inheritors) are often in their highest wage-earning years when their parents pass away, there is a high likelihood the HSA distribution would be subject to very high tax rates.
No Beneficiary: If there is no beneficiary named, then the entire HSA is treated as taxable income on the deceased account owner’s final tax return.
To avoid the situation where a non-spouse beneficiary inherits the full HSA account and is hit with the entire balance as taxable income, it is often a best practice for HSA account owners whose beneficiary is not their spouse to begin taking HSA distributions for qualified medical expenses if their health starts to deteriorate (i.e. a deathbed drawdown).
The quickest and easiest way to do this is to immediately reimburse themselves for all the qualified medical expenses that they’ve tracked over the years since establishing their HSA account. Then going forward, they may want to consider paying all their current qualified medical expenses using HSA funds.
Further, since an individual may be impacted by a sudden illness that leaves them unable to execute an immediate drawdown of HSA funds to reimburse past expenses on their own, it is always important to notify family and your attorney-in-fact (i.e. Power of Attorney) of your HSA strategy and the location of your saved receipts. This will allow them to implement a timely drawdown of your HSA account prior to death if you are unable to do so yourself.
Key Takeaway:
It’s important to ensure you have the appropriate beneficiary listed on your HSA account, and your family is aware of your HSA strategy.
Conclusion:
HSA accounts provide substantial tax benefits that are unmatched by other accounts. By creating the trifecta of an upfront tax deduction, tax-free growth, and tax-free distributions for qualified medical expenses, these accounts are unmatched in their tax efficiency.
Unfortunately, many eligible individuals don’t maximize their contributions to health savings accounts, and those that do often still don’t realize the significant benefits that can be achieved by saving receipts and allowing the account to grow over time.
Given the significant increases in the cost of health care over the years, couples can expect to pay over $315,000 in health care costs in retirement excluding long-term care. Using an HSA account to prepare for those costs can provide substantial tax benefits over time and make the costs more manageable in the long run.
If you are interested in connecting with one of our Family CFOs to learn more about how HSA accounts can play a pivotal role in your retirement plan and reduce the taxes you pay over your lifetime, we would love to connect to see if what we do is right for you.
