Updated: Sep 30, 2021
From a tax protection standpoint, a Health Savings Account (HSA) is one of the newest and most beneficial accounts accessible to investors. Unfortunately, they aren’t open to everyone as an individual can only fund their HSA if they participate in a High Deductible Health Plan (HDHP) with their employer or through one of the Affordable Care Act exchanges.
Many people are familiar with Traditional retirement accounts that allow for a tax deduction in the year of contribution and tax deferral until withdrawal after age 59.5. Many are also familiar with a Roth retirement account that allows for tax-free growth and withdrawal after age 59.5. However, an HSA, differs in that it allows for an immediate tax deduction, tax-free growth, and then tax-free distribution as long as the distributions are used for qualified medical expenses. To further illustrate, the below table outlines the tax benefits for each type of account:
An HSA can be a powerful wealth-building/risk migrating tool for those who have access to them. Another benefit to an HSA is that if by some miracle you have overfunded an HSA and know you won’t need the money later in life, the funds can be withdrawn penalty-free after age 65 and will simply be taxed as a Traditional retirement account. Many people plan to use HSAs as a way to supplement their retirement savings while providing some security to cover deductibles or other healthcare costs not covered by their insurance if needed. It’s important to note that there’s a 20% penalty for funds withdrawn before age 65 for non-medical purposes (a Traditional account only penalizes 10% for early withdrawals) as well as any taxes due. There are even some creative strategies allowed under current tax law where someone could pay their medical costs out of taxable savings, save up their receipts for medical expenses, and then years later withdraw funds from an HSA to reimburse themselves for the earlier payment after years of tax-free growth. For example, Tom has $100 in his HSA and is billed $100 for his deductible on a recent doctor visit. Instead of withdrawing the $100 from his HSA, Tom pays the $100 out of his savings account and saves his receipt. Then 30 years later when Tom’s HSA has grown to $1,006.27 (assuming an 8% rate of return), Tom can withdraw $100 tax-free to reimburse himself for the prior expenses and still has over $900 in his HSA working for him.
For the most part, HSAs have begun to replace Flexible Savings Accounts (FSAs). HSAs have one large advantage over an FSA. FSAs were also established to provide a tax advantaged way to save for medical expenses, however, unlike an HSA funds, funds in an FSA do not roll over from year to year. If you funded $800 into your FSA but only spent $400, your other $400 was lost. Because of the tax advantage of HSA accounts, the IRS limits how much someone is allowed to contribute to them annually. For 2021, an individual is allowed to contribute $3,600 while families can contribute up to $7,200. Those 55 years or older by the end of the tax year can contribute an additional $1,000 to their HSA and contributions made by an employer to an HSA are included in the limit. The benefits associated with an HSA are enough to pursue if the option is available to you, if you’d like to further navigate we’ll discuss in our next meeting.