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The magic of Health Savings Accounts

Posted by Ben Miller Posted on May 12 2019

As health insurance premiums rise, health savings accounts (HSA) are becoming more prevalent.  Why?  Health insurance premiums for high deductible health insurance plans (HDHP) are generally cheaper than traditional health insurance plans.  In many cases, in tandem with HSAs, HDHPs are becoming the only affordable health insurance option for many individuals.  In this post I provide the nuts and bolts of why HSAs are so beneficial from a tax perspective.

HSAs were established in 2003 with the intent of putting more responsibility into the individual’s hands.  Congress’s thought was, “if individuals have more control over how their health dollars are spent, those dollars would be more wisely spent”.  When individuals participate in a HDHP they have the option of also contributing pre-tax dollars to an HSA.  When distributions, used to pay for medical expenses of the individual, the spouse, and their dependents, are distributed from the HSA account they are 100% tax free.

When an individual signs up for HDHP insurance through work and contributes to their HSA, both amounts are taken out pre-tax.  What does this mean?  This means that the amounts income and payroll taxes are calculated on are reduced first before the taxes are calculated.  In the examples assume Ross is a single, non-married individual and has HDHP coverage the entire year.

Example 1 – Ross works as a bouncer in 2018, removing unruly patrons.  Ross’s gross wages were $52,000.  His total HDHP premium is $1,300 and his total HSA contribution is $2,500.  Instead of calculating the income tax and payroll tax (FICA) withholding on $52,000 it was instead calculated on $48,200 ($52,000 – $3,800).  Say Ross’s total income tax rate was 30% and his FICA tax rate is 7.65%.  Ross saved $1,431 ($3,800 x 37.65%) in overall tax. 

Another positive aspect of HSAs is the ability to make after-tax contributions into the account.

Example 2 – The following spring Ross gives his CPA his tax information.  Ross’s CPA notices he is in the 30% overall income tax bracket.  Before Ross’s CPA finalizes the tax returns the CPA recommends Ross contribute $950 to his HSA to max it out for 2018.  Ross has until April 15th, 2019 to make this contribution for the 2018 tax year.  Ross sees tax savings of $285 ($950 x 30%).

An item to note: In the two examples above do you see a difference?  It is the FICA tax.  Ross making contributions through his employer avoids the FICA tax.  When he writes the $950 check to the HSA he only gets the income tax deduction not the FICA tax deduction.

Flexible Savings Accounts (FSA) are another way to put away pre-tax dollars for medical expenses.  Much like HSA accounts the individual specifies how much they’d like taken out of their paycheck and these amounts avoid income and payroll tax similar to HSA contributions.  FSAs, however, are a “use it or lose it” account.  If the individual has not spent the funds inside the FSA by the end of the tax year those funds are lost forever.  The individual’s employer may allow a grace period of March 15th of the following year, but again the funds have to be spent.  Amounts contributed to an HSA are the individual’s money forever, sort of like a contribution to a 401k retirement account.  The tax law forbids the individual from contributing to both an FSA and HSA in the same tax year i.e. no double-dipping.

Speaking of retirement let’s address that advantage.  Depending on who the custodian (banks for example) is for the HSA account the individual may be able to invest the funds residing inside the HSA.  This allows the individual to earn an investment return on funds sitting inside the account.  This sounds like a 401k doesn’t it?  Everyone reading this will have medical expenses at some point in their life.  If possible, it makes sense tax-wise to fully fund these each year.

HSAs are the rare unicorn found in the tax code.  Nowhere else in the code does the government allow pre-tax contributions, tax-free investment growth, and tax-free withdrawals from the same account.

If medical premiums continue their ascent each year, an increasing amount of individuals will be trying to find ways to reduce their exposure and HDHPs combined with HSAs are a viable option to combat the increases.  Message me with any questions.