This blog accompanies Episode 15 of The Retirement Oasis Podcast. To listen to the podcast, you can visit your favorite podcast platform (Apple, Stitcher, Podbean, etc.) or go here:
There are good tax planning strategies and then there are great tax planning strategies. Today, we will review what I think is a great tax planning strategy in many situations. It does not work for everyone, however, and how you implement the strategy is key. In today’s episode, we will review the basics of a Health Savings Account, the potential tax benefits of this strategy, and key considerations for implementation. Please consult your own tax advisor as it relates to your individual situation because I don’t know if this strategy makes sense for your situation.
Basics of a Health Savings Account
What is a Health Savings Account? A Health Savings Account (“HSA”) is an investment account where you can contribute up to a certain dollar amount each year and use the investments for qualified medical expenses on a tax-favored basis. To be eligible to contribute to this account you must be enrolled in a health insurance program that is deemed a High Deductible Plan.
Compared to a Flexible Spending Account.
It is important to note that this is not a Flexible Spending Account (“FSA”). Many people think these are one and the same and, unfortunately, quickly dismiss enrolling in a Health Savings Account. In understanding an FSA and the differences between an HSA, you will be able to better understand the HAS. An FSA is similar in that it is a tax-advantaged savings plan for qualified medical expenses. While there are a few differences in an FSA v. H.S.A., the main difference is that the annual savings to an FSA have to be used up by March of the next tax year. It is a “use it or lose it” type of program – if you don’t have qualified medical expenses for the year, then you forfeit your savings. Thus, many people – perhaps some of you – contributed to an FSA only to lose money because you either did not have enough medical expenses during the year or you forgot to turn in your request to get refunded for the medical expenses. In any event, may people shy away from FSAs because they fear getting burnt in this manner.
Compare that to Health Savings Account where the savings in a H.S.A. do not have to be used each year. In contrast, the savings or investments in a H.S.A. can be held for the long-term – well into one’s retirement years. Not only does this allow you to save more to the account since you don’t need current year qualified medical expenses, but this account can grow tax free for a longer period of time. That can potentially result in significant tax savings over time.
High Deductible Plan requirement.
To be eligible, you must be enrolled in a High Deductible Plan (“HDP”). As you would expect, the tax code defines what is considered a High Deductible Plan. When you enroll for health insurance, your employer’s benefit package or third-party insurance provider will generally indicate whether the plan is a HDP or H.S.A.-eligible. There are generally two factors that make a plan qualify as an HDP: the deductible has to be greater than or equal to a threshold amount (the “Minimum Deductible”) and the out-of-pocket costs cannot exceed a certain threshold (the “Maximum Out-of-Pocket”). As of 2022, an HDP is a health insurance policy that has such following thresholds, based on whether the policy is a Single Plan or a Family Plan: a) Single Plan: Minimum Deductible: $1,400, Max Out-of-Pocket: $7,050; b) Family Plan: Minimum Deductible: $2,800, Max Out-of-Pocket: $14,100. There are other requirements that the insurance policy have that make it a HDP plan, but we will rely on our insurance providers to ensure they qualify.
Amount to contribute.
The maximum amount that you can contribute on an annual basis is not huge, but it certainly can add up over time. If you are eligible for the full year, you can contribute (2022) up to $3,650 if you are in a Single Plan or $7,300 if you are on a Family Plan. If you are 55 and over, you can contribute an extra $1,000 per year. Note that if both spouses are eligible for a HDP with their respective employers, there needs to be coordination of how the accounts are funded because there is a total family limit that can be contributed even if one spouse is on a Single Plan and the other spouse is on a Family Plan. You do not want to overfund these accounts – otherwise, a penalty for overcontribution could apply.
Compared to retirement plan savings.
Depending on the numbers, these vehicles could be even more beneficial than saving to typical retirement plans. You obviously want to save to your company retirement plan to get a match. After that, a good argument could be made that you should look next to saving to your H.S.A., but this depends on your particular situation and health insurance structure and a variety of other factors.
Overall Benefits and Disadvantages of a Health Savings Account
There are many benefits from implementing a H.S.A., including minimizing taxes and lower insurance premiums. Speaking of tax benefits, let’s explore the four primary tax advantages of Health Savings Accounts: a deduction or deferral for the contribution against ordinary income taxes, a deduction for FICA tax purposes for HSAs through employers, tax-deferred growth, and tax-free distributions.
Tax deferral or deduction.
The tax deferral or deduction can be significant. As an aside, a contribution to a H.S.A. through your employer is technically a deferral. It does now show up on Box 1 of your W2. If you had your H.S.A. outside of work, then this shows up as a tax deduction on your tax return. For discussion purposes, I will refer to this as a tax deduction. The tax deduction benefit is generally your marginal tax rate times the amount of the contribution. Let’s say you are on a Family Plan and contribute $7,300 and that you are in the 24% tax bracket. The tax deduction benefit is over $1700. If you are in a high-income tax state, the benefits can be more. So, let’s say you are in Georgia and your marginal tax rate is 6%. Well, that is a total tax deduction of 30% (ignoring any potential state income tax itemized deduction), bringing the savings to nearly $2,200.
You may also get a FICA tax benefit. For employees, this tax benefit can generally range from 1.4% to 7.65%, depending on your level of wages. If your wages are well above the Social Security tax wage base of $147,000 (2022), then the tax benefit is likely just 1.4%. If it is below that, the tax benefit could be 7.65%. If your FICA wages were such that you would get the benefit of a 7.65% tax break, that would be another $550.
The tax-deferred growth can also result in significant savings. Just like with a Traditional IRA or a Roth IRA, the growth on the earnings is not taxed while the funds remain inside of the HSA. Since taxes are not “leaked out” as an expense, that allows the compounding to have a bigger impact. Effectively, you are receiving growth on the amount that would otherwise go to taxes. That can be huge over the long-term. Hence, we generally recommend that the H.S.A. is treated as a long-term investment. All else equal, the longer the funds can stay in a tax-deferred bucket, the greater the tax benefits.
Finally, and quite significantly, the final potential tax benefit is that the earnings and growth are generally not taxed when withdrawn as long as such funds are used for qualified medical expenses. So, it is like a Roth IRA in that regard. Getting tax-deferred growth is one thing, but having all of the earnings tax-free is another.
If the funds are not used for qualified medical expenses, it is not the end of the world; however, you should always strive to have the distributions qualify for tax-free treatment, when possible. If the distributions occur before age 65 and it is not for qualified medical expenses, the earnings withdrawn are subject to both ordinary income taxes and a 10% penalty. If they are withdrawn after age 65, then the earnings withdrawn are just subject to ordinary income taxes and avoid that extra penalty.
So what are qualified medical expenses? Qualified medical expenses are health-care expenses, as defined by Internal Revenue Code 213(d), that are paid by you, your spouse, or your dependents. These include laboratory fees, prescription and nonprescription drugs, dental treatment, ambulance service, eyeglasses, and hearing aids, as well as many other health care expenses. HSA funds may also be used to cover health insurance deductibles and co-payments. Note that over-the-counter (OTC) medications are no longer considered a qualified medical expense except that OTC medicines prescribed by a physician and insulin will still be considered qualifying expenses.
Generally, health insurance premiums, including HDHP premiums, are not qualified expenses, except for the following types of health coverage (1) COBRA coverage, (2) qualified long-term care insurance, (3) health coverage maintained while receiving unemployment compensation, and (4) Medicare insurance.
For a list of qualified medical expenses, see IRS Publication 502.
There are other benefits of carrying a High Deductible Plan.
The other major benefit of going the High Deductible Plan route is that the insurance premiums may be significantly less, depending on your health insurance plan and how much your employer helps cover your insurance costs. In other cases, the difference is not as great as you would think it would be. This should certainly be factored into the analysis.
In some cases, your employer may even contribute to your savings account. That’s in addition to them subsiding a large portion of the insurance premiums. For those employers that contribute, the amount generally averages from $700 (for a single) to $1,300 for a family. About half of the employers make some type of contribution.1
Disadvantages of a Health Savings Account and High Deductible Plan
While there could be some nice advantages with a Health Savings Accounts, there are some drawbacks. Of course, the primary disadvantage is that the insurance deductible is generally higher. So, if you have high medical costs, then you may have to come out-of-pocket for these costs. This is one of the main reasons more people do not enroll in an HDP.
Another disadvantage of the H.S.A. is the need to administer this account. You will not only need to make sure it is invested wisely, but you will also want to keep the receipts of your qualified expenses to please the tax man.
Key Considerations on Implementing a H.S.A.
If you decide to enroll in a High Deductible insurance plan and to enroll in a Health Savings Account, there are various considerations to take into account upon initial set-up and throughout the life of the account.
When to withdraw.
As we discussed above, the general goal is to allow the funds to remain in the tax-free bucket as long as possible. The longer you can keep the funds in a tax-free bucket, the better, in general. (There may be some cases as part of your overall tax planning that you may want to withdrawal earlier if such withdrawal would allow you to remain in a lower tax bracket.) However, you don’t want to get too greedy by delaying the withdrawals and pass away with too large of a balance in the H.S.A. If you pass away with the H.S.A., the account goes to the beneficiary. If it goes to your spouse, then there are no taxes at that point. However, if the H.S.A. passes to someone other than your spouse (or charity), the funds have to be distributed by the next year. The beneficiary can use the funds to pay for the deceased owner’s qualified medical expenses within 12 months day of death and still qualify for tax-free treatment; however, if the funds have to be distributed to the beneficiary and there are no qualified medical expenses, then the distribution is treated as ordinary income to the beneficiaries in that year of distribution. The beneficiary does not have the option to spread out the income over multiple years like they can with an IRA. Thus, the distribution could be taxed at a very large tax rate if the beneficiary has other income in that year (e.g., wages from a regular job) and/or if the distribution is relatively large.
Some commentators say they are not too concerned about not being able to use large H.S.A. balances in later years because they suggest that there is a likelihood that there will be significant qualified medical expenses in one’s later years due to high medical costs associated with one’s elder years (e.g., a last major illness). This may be the case in some situations but not always. Health insurance may cover the bulk of the expenses if one has a good Medigap policy – it just depends on the situation. In any event, we recommend withdrawing the funds gradually in retirement. Some amounts for nursing homes or home health care could qualify, but not everyone has major expenses even at that stage.
The timing and amounts of distributions will vary based on the individual’s circumstances and account size. If the individual was able to accumulate significant qualified medical expenses during the years they were contributing to a H.S.A. and if they saved the receipts during that time, then those “banked” expenses can be used in later years. If you were confident that you and/or your family would remember – and be able to locate -- these accumulated receipts, then you might be tempted to delay the withdraws until later years. Theoretically, you could wait until your 70s. I would caution you, however, in relying on this strategy too much as records get lost and memories fade. Perhaps you are meticulous about your recordkeeping currently, but will this be the same as you age and as you make a move or two in retirement? We often recommend making withdrawals in one’s mid 60’s to 70’s, but again this varies by situation. Regardless, I would communicate with key family members or others that may need to be in the know eventually.
Asset Allocation for your Health Savings Account.
Another important aspect of HSAs is that they generally allow the savings to be invested. While the rules of the particular H.S.A. may require a certain amount of the funds to be in cash (say $1,000 or $2,000), most of the funds can be invested in a variety of funds, depending on the investment choices offered by the provider. Too often, the decision of the asset allocation and choice of funds receives little attention. While in the early years, the asset allocation choice may not result in a huge difference in earnings. However, as the account grows, the asset allocation can make a huge difference.
We have seen accounts just languish in cash at a significant opportunity cost. Or, they may invest in a target date fund that ties to their intended retirement age. Target Date Funds (TDF), while appropriate in some cases, may not result in the best mix of stocks and bonds since it is often recommended that the withdrawals take place well after retirement. Investing in TDFs may result in a significant over-allocation to bonds than what one’s true time horizon may suggest. This costly mistake can cost tens of thousands of dollars in some situations.
I won’t get into the weeds of choosing the best asset allocation or choosing the funds in this episode, but it is certainly a decision that should not be taken lightly.
Through Employer or on your own?
In general, HSAs can be done through your employer or outside of your employer as an individual. In general, if you have access to an employer based H.S.A., then that is generally the preferred route because it has one tax advantage that the individual plan does not have – you may receive a FICA tax deduction for contributions to HSAs through your employer. That is not the case for an individual plan. (This is a rule that should be changed by Congress, however more administratively difficult this should be.) If your employer does not offer a H.S.A. yet offers a HDP or if you are self-employed and have not set up a H.S.A. through your company, then setting up an individual H.S.A. may still be quite advantageous. There are various providers out there such as Lively (at https://livelyme.com/) and Health Savings Bank that offer various investment options at reasonable costs. We like using the combination of Lively as the H.S.A. administrator with TD Ameritrade (due to become Schwab) as the custodian platform which allows you to choose a wide array of investments to more customize your investment holdings and asset allocation.
Cash Flow and limited savings.
If you have limited cash flow or ability to save, saving to an H.S.A. may not make sense. It is best when you obviously have qualified medical expenses and you don’t tap into the funds until retirement or even much later than retirement. If there is a chance you will need the funds right away, you should not contribute to the H.S.A. because you want to avoid the 10% penalty. If you are deciding between saving to an employer retirement plan such as a 401k and H.S.A., I would recommend saving to the 401k to the extent of the employer match. After that, the H.S.A. generally is more beneficial if you will indeed eventually have enough medical expenses – either currently in retirement or accumulated – to cover the withdrawn amounts. Compared to a 401k type of plan, the H.S.A. has the benefit of getting both a tax deduction or deferral at the time of the contribution and tax free upon withdrawal. A 401(k) only offers one of the benefits – either a tax deduction for a traditional 401(k) or no tax deduction and tax-free growth for a Roth 401(k). Moreover, the H.S.A. has the potential FICA tax deduction as well. Of course, you need to only save to these types of deferred accounts if it otherwise makes sense for your overall retirement situation. If you are retiring early and don’t have enough outside funds and cash flow to meet your needs, you may not want to be as aggressive in saving to these tax-deferred or tax-free plans.
Should you roll over your H.S.A. at retirement?
That brings up the idea of what to do with the H.S.A. at retirement. While you can generally leave the accounts in your H.S.A. established at your work after retirement, you should review the investment choices that are offered and the expenses in deciding whether it makes sense to roll it over. In generally, it often makes sense to roll over the funds to a third party H.S.A. provider that has more investment choices and potentially lower fees. As discussed above, and as at the time of this writing, Lively and Health Savings Bank are a couple of decent options available, among others. The rollover is generally done as a trustee-to-trustee transfer in which you will not receive a check directly. The easiest approach is to have the funds go from one account to the other without you seeing the funds. After the rollover, the asset allocation should be tied to your overall plan and need for the funds.
Pre-retiree health insurance.
Another point that is often overlooked is the ability to take advantage of the H.S.A. even when you are retired. Just because you retire and are no longer working does not mean that you can no longer contribute to a H.S.A. (You can’t contribute to a H.S.A. after you enroll in Medicare, however.) I hear some people say that since their cash flow is limited at this time that it does not make sense to contribute to a H.S.A. Although cash flow should be looked at, there may be other assets – rather than cash flow -- that can be used for saving to the H.S.A.
Flexible account for withdrawal strategies.
The HSA can also be used as a flexible account for flexible withdrawal strategies in retirement. While we often recommend letting this type of account – like Roth IRAs – to grow tax free as long as possible, it can sometimes be used to make withdrawals to minimize overall income taxes. If you have to otherwise withdrawal from a Traditional IRA that would knock you into a higher income tax bracket or cause higher capital gains taxes as a result, then withdrawing from a H.S.A. can be beneficial. We often talk about tax diversification for these exact benefits. An H.S.A. can indeed be another vehicle to get proper tax diversification in retirement.
Be aware of limitations on contributions.
Most of you are aware of this, but remember that you cannot contribute to a FSA and H.S.A. at the same year. There is an exception in that you can contribute to a Limited FSA (dental and vision) during the same period.) You don’t want to make this mistake because things can get messy.
After looking at the various benefits, disadvantages, and nuances, you might be wondering whether you should contribute to a H.S.A. While this is a highly individualized question, I think it will make sense for many individuals. It is a matter of weighing all of the potential tax benefits and the insurance premium savings versus the extra costs that you may have to pay in insurance coverage. This will vary based on your income tax situation -- both now and in the future – as well as your health insurance options. Take time to properly analyze this decision, and evaluate it from a long-term perspective.
1For a review of the HDHP marketplace, see https://www.kff.org/report-section/ehbs-2021-section-8-high-deductible-health-plans-with-savings-option/#:~:text=The%20average%20general%20annual%20deductible,amounts%20reported%20in%20recent%20years.