If you made it through tax time and had an uncomfortable bill to pay, here’s one idea to save a few dollars in future years while saving for an almost certain future need: contribute to a Health Savings Account.
If you are enrolled in a high deductible health care plan as a single participant, you are eligible to contribute $3,450 per year to an HSA in 2018. If you participate in a family plan, the contribution limit increases to $6,900. If over the age of 55, there is an additional $1,000 catch up allowed as well – All with no income eligibility requirement!
There are actually three layers of tax breaks built into an HSA:
Tax Break # 1: HSA contributions are tax deductible on the Federal and most State income tax levels and are in fact also exempt from FICA taxes as well if made through payroll deductions.
A 57-year-old couple earning $120,000/year participating in Spouse #1’s family high deductible health care plan can contribute $6,900 + $1,000 catch up for Spouse #1 + $1,000 catch up for spouse #2. Spouse #1’s contributions are made throughout the year by payroll deduction so are exempt from FICA taxes (6.2% Social Security + 1.45% Medicare= $604.35), and Federal taxes (22%= $1,738). Spouse #2 also gets the Federal tax deduction (22%= $220). Additionally, most states will allow HSA contributions to be deductible (if in 3% Ohio State bracket = $267).
In total, this couple will save $2,829.35 in taxes in one year alone! Of course, as income rises, one won’t ultimately benefit from the FICA relief, but the Federal deduction is worth much more at that point.
Tax Break #2: Contributions are fully vested immediately, can roll over each year and can often be invested (we recommend a balanced mutual fund, of course – No risky individual stocks!), which leads to the best part: invested HSA dollars grow completely tax free. This is a huge advantage for high income earners that are currently subject to the max capital gains rates (20% capital gains + 3.8% Medicare surtax) in a normal taxable account.
If a couple earning over $479,000 (subject to 23.8% capital gain rates) is contributing $6,900/year to their HSA and investing it in a balanced mutual fund earning 8% annually for ten years, they will have an HSA value of $107,953.86, having contributed $69,000. As they draw the funds out over time tax free, there is long term savings of $9,271.02 by avoiding capital gains rates on the growth amount ($38,953.86 x 23.8%). Due to the power of compounding, if the couple did this over 20 years, the investment growth is of course much larger ($203,018.16) and therefore the tax savings is larger as well: $48,318.32!
Tax Break #3: Medical expenses can be paid directly from the HSA or a person can pay out of pocket and reimburse themselves at a later date; either way, there is ZERO tax liability to withdraw funds when used for medical expenses or reimbursing for past medical expenses made while the HSA was open. If you are organized enough to hold onto your medical receipts, you can even let the invested HSA money continue to grow within the HSA tax free (to maximize Tax Break #2!) and reimburse yourself anytime in the future for medical expenses you make now. The IRS designates what medical expenses are HSA eligible, but some of them may surprise you. In addition, HSA dollars can be used to pay for future long-term care insurance premiums, COBRA coverage, or Medicare coverage upon reaching age 65.
There are a couple of potential obstacles worth noting when dealing with Health Savings Accounts – you have to call the Insurance company to make sure your plan is eligible to allow contributions to an HSA. Not ALL HSAs have access to good investment options. Potentially the biggest downside, beneficiary HSAs are not treated so favorably by the IRS as of now, outside of a Spousal relationship.
Overall, we’ve found HSAs to be amazing tools to assist clients with tax advantaged savings. If cash flow allows and your Health Care Plan is eligible, an HSA is definitely worth considering.
Update: The IRS announced HSA maximum increases starting in 2019 – $3,500 for individuals and $7,000 for families.
At Total Wealth Planning, we specialize in helping clients save in tax efficient ways. Please call or email Joel Musser or another member of your Total Wealth Planning team at 513-984-6696 if you have questions about how an HSA could be included in your overall investment strategy.