Every year, most companies that offer employee benefits such as retirement savings plans and health insurance have an open enrollment period. This period typically lasts between two to four weeks near the end of the year and allows individuals to make changes to their benefits elections, add or drop dependents, and learn more about the benefits they have access to.
So with open enrollment periods quickly approaching, I want to take a moment to discuss the value of an increasingly popular health insurance benefit that many employers are offering, but which a lot of people still do not take advantage of: the Health Savings Account.
What Is a Health Savings Account?
A Health Savings Account (HSA) is a medical savings account that is available to United States taxpayers who are enrolled in a high-deductible health plan (HDHP). Every dollar contributed to an HSA is pre-tax (or tax-deductible), much like the money you contribute to a 401(k). You can then use the money in your HSA to pay for qualified medical expenses, entirely tax-free.
High-deductible health plans in and of themselves may sound like a bad deal at first. I get it – who wants to pay out of pocket every time they go to the doctor until they meet their high deductible? In 2021, the minimum deductible for self-only plans is $1,400 ($2,800 for family plans).
And it’s true, by enrolling in a high-deductible health plan, your employer can provide less expensive health insurance benefits and save more money for their own bottom line. But employers are not the only ones who benefit from HDHPs.
When you’re a generally healthy individual and you pair a high-deductible plan with an HSA, you have more opportunities to save on taxes, make healthcare choices that are more aligned to your needs and circumstances, and potentially reduce your healthcare expenses.
How Does a Health Savings Account Work?
Many employers who offer high deductible health plans also offer an accompanying HSA to make life easier. If your employer only offers a high deductible health plan and no accompanying HSA, you can still open an HSA with any bank or custodian that offers one.
Once the account is set up, you will receive either a debit card or checks linked to your HSA that you can use to pay for qualified medical expenses on a tax-free basis (see below for more about qualified expenses). And unlike Flexible Spending Accounts, your HSA balance carries over every year.
As if the tax-free savings and purchasing power aren’t enough to make you want an HSA, there’s one more unbeatable benefit. Once the balance in your account reaches a threshold that you set ($2,000, for example), every dollar you contribute beyond that threshold is available to be invested in the markets.
This feature not only makes HSAs a great healthcare tool; it makes them a great retirement planning tool as well.
The Triple Tax Advantage of a Health Savings Account
Health Savings Accounts are currently the only type of account with a triple tax advantage:
- Your contributions are pre-tax or tax-deductible
- Your investments grow tax-free
- Withdrawals are tax-free if used for qualified medical expenses
Here’s how the pre-tax advantage works: If you have an HSA through your workplace, you determine how much you want to contribute (up to government-regulated maximums) to the account each year during your enrollment period. The annual amount you determine is divided by your pay periods for that year. Every pay period, that amount will be automatically deducted from your gross earnings and contributed to your HSA.
If you’re contributing to an HSA outside of your employer (remember, you still have to be enrolled in a high-deductible health plan to qualify for an HSA), you’ll deduct those contributions from your annual earnings for that year’s tax return. Either way, the pre-tax or tax-deductible contributions lower your overall taxable income for the year, thereby saving you money on income taxes.
The second tax advantage involves tax-free investment growth. Once your investment threshold is reached, every contribution you or your employer makes to your HSA is available to be invested. Not only is this a great way to grow your wealth, but these investments are also able to grow entirely tax-free.
And of course, the third tax advantage means that both the principal you’ve saved and the interest you’ve earned can be withdrawn tax-free if used for qualified medical expenses. Any withdrawals you make that are not used for qualified medical expenses are taxed at your regular income tax rate.
For employer-sponsored HSAs, there’s actually a less well-known fourth tax advantage that can further benefit both you and your employer. Contributions you or your employer make to an HSA are not subject to Social Security and Medicare taxes (whereas 401(k) contributions are). This fourth tax advantage encourages some employers to make even larger contributions to their employees’ HSAs than they would otherwise be able to.
Health Savings Account Rules
All these great tax benefits don’t come without regulations. The most important regulations to be aware of are contribution maximums and qualified expenses that allow you to make tax-free withdrawals.
The annual amount you can contribute to your HSA is capped by IRS-mandated maximums, which are subject to change every year. Individuals can contribute up to $3,600 to HSAs with self-only coverage or $7,200 to HSAs with family coverage. Individuals over 55 may also make $1,000 catch-up contributions.
To take advantage of the third tax benefit, you’ll only want to use your HSA funds for qualified medical expenses. However, qualified medical expenses is a broad category, and may include expenses such as, but certainly not limited to:
- Health insurance deductibles
- Copays
- Coinsurance
- Routine preventive procedures
- Ambulance services
- Emergency room visits
- Medical supplies such as bandages and first-aid kits
- Dental treatments
- Pregnancy tests
- Feminine hygiene products
- Fertility treatments
- Eye examinations
- Hearing aids
- Prescription medicines
Regulations governing HSAs are frequently updated, so these expenses may not be accurate at the time of reading. We encourage you to consult this list of qualified expenses from the IRS as well as your Plan Documents to confirm the reimbursable expenses you’re eligible for.
Who Benefits the Most From a Health Savings Account?
Health Savings Accounts and high deductible health plans aren’t for everyone. In general, these types of health insurance plans are best for healthy individuals who don’t have high medical costs and don’t foresee needing expensive medical care in the near future. For this reason, young professionals often benefit from HDHPs and HSAs.
HDHPs with an HSA may also be a good option for generally healthy pre-retirees who are looking for tax-efficient ways to save for future medical costs. The HSA acts as a safety net for pre-retirees to use for medical costs they know they’ll likely need as they get older. This type of account can provide funding for those costs without the risk that they’ll have to draw from their central nest egg, with the added bonus that the funds will be entirely untaxed.
How Does an HSA Fit Into Your Financial Plan?
As open enrollment approaches, we know you may have questions about how your benefits selections fit into your overall financial plan, especially if you’re considering an HSA. Just like your financial plans and strategies, the benefits you choose should be dependent on your needs, circumstances, and goals for your future.
At Caviness Wealth Management, we can help you make sure the benefits you choose align with the rest of your financial decisions. Click here to schedule a conversation to see how we can help you create or update a financial plan that optimizes the benefits options you have available.
Withdrawals from an HSA account may be tax free, as long as they are considered qualified. Unqualified withdrawals prior to age 65 are subject to a 20% penalty and ordinary income tax. Future tax laws can change at any time and may impact the benefits of HSA accounts.
The content and opinions in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
