Health Savings Accounts: An Under-Rated Retirement Plan

Most taxpayers are aware of employer-sponsored retirement plans like 401(k) accounts and individual retirement accounts like IRAs. They may even be aware of Health Savings Accounts (HSAs) as a way for employers to pitch in for employees’ medical expenses. Many, however, are unaware of the full benefits of HSAs and how the rules can be leveraged to provide retirement planning strategies beyond covering current and future medical costs.

What is an HSA?

Health Savings Accounts (HSAs) were created in 2003 to give taxpayers a tax benefit for saving for their own medical expenses. The idea was that taxpayers would be allowed to make a deductible contribution to an HSA, where it could be invested and grown tax-free, then pulled out tax-free to cover medical expenses. Due to the fact the money is contributed tax-free, grows tax-free, and is pulled out tax-free, it is often referred to as a “Triple Tax Benefit” account, unlike Traditional retirement accounts where money is taxable when withdrawn, or Roth retirement accounts, where money is taxable (that is, non-deductible) when contributed.

Who May Use an HSA?

Not everyone can contribute to an HSA. In order to contribute, the taxpayer must be covered by a so-called High Deductible Health Plan (“HDHP”). These are health plans that fall within certain IRS guidelines, and generally require a taxpayer to pay more out of pocket than traditional health insurance plans. If, however, a taxpayer makes a contribution during a month when they are covered by an HDHP, and later is not covered by a HDHP, they may still maintain their HSA and either let it grow or take distributions.

Unlike certain other retirement accounts, there are no maximum income limits or earned income requirements to contribute to an HSA. Because of this, high earners or taxpayers living off investment income, who may be unable to contribute to certain other accounts, may still be able to receive the tax benefits of contributing to an HSA.

What is a High Deductible Health Plan?

Generally speaking, an HDHP is a health insurance plan that that has at least a certain minimum deductible but stays below a certain maximum yearly out of pocket limit. For 2020, the minimum deductible is $1,350 for individuals, and $2,700 for families, while the maximum out of pocket is $7,600 for individuals and $13,500 for families (excluding out of network services). These plans generally have low premiums but higher out of pocket medical costs than other plans.

While the general rule seems fairly straight-forward, the IRS regulations make things more complicated than they may appear. For instance, a plan may list a deductible and out of pocket max that fall within these limits, but due to how the IRS defines such rules, still not be a HDHP. For instance, co-pays or co-insurance rules could cause the plan to fall astray of the IRS deductible rules, despite the deductible listed on the face of the policy falling within the limits. Most taxpayers are therefore best served by only opening or contributing to an HSA if their insurance company specifically markets the plan as an HSA-compliant HDHP.

Taxable vs. Non-Taxable

As mentioned above, in order to be tax-free, distributions typically must be used to pay for qualified medical expenses. They do not, however, have to be used to pay such expenses directly, and are instead often used to “reimburse” a taxpayer for such expenses. Taxpayers self-certify the amount of their qualified expenses, but should maintain records against the possibility of an audit. Additionally, distributions that are not used for medical expenses incur a 20% penalty in addition to the taxes due.

At age 65 and above, however, the aforementioned penalty is waived, meaning that while funds can still be withdrawn completely tax and penalty-free for qualified medical expenses, they can also be withdrawn for any purpose, and only incur the same tax treatment as would a Traditional retirement account like a 401(k) or IRA.

Qualified medical expenses include most out-of-pocket expenses, like doctor’s visits, ambulances, medical devices, dental and vision expenses, drugs (including, for tax years 2020 and later, over the coutner drugs), and many other expenses listed in IRS Publication 502, which covers a broader range of products and services than people may assume. Certain medical expenses, however, are excluded. Excluded expenses include normal health insurance premiums, though long-term care, COBRA, insurance premiums while receiving unemployment compensation, and health premiums (other than Medicare supplemental policies) for those 65 and older are allowable. For a complete list refer to IRS Publication 969.

Notably, qualified medical expenses do not have to be current year expenses. That is, you can “reimburse” yourself for any medical expenses incurred from the time your HSA (or rolled over account such as a prior HSA or Archer MSA) was created. Taxpayers who wish to defer distributions and let their account value grow, but still want to take tax-free distributions, can keep a record of all medical expenses, and “bank” the medical expenses to offset a distribution in a future year. For this reason, taxpayers with a HDHP who are not ready to make HSA contributions should nevertheless consider opening an account (even if not funding it), so that they can begin to bank medical expenses.

Contribution Limits

The contribution limits for HSAs depend on whether the underlying HDHP covers an individual or a family. For 2020 the limits are $3,550 for self-only plans, and $7,100 for family plans, with an additional $1,000 “catch-up” contribution for individuals age 55 or older. The limit applies to the combined amount of employer and employee contributions. Individuals who are age 65 or older and are enrolled in Medicare may not contribute to an HSA.

Individuals who do note enroll before December 1^st and remain enrolled for at least 13 months may have to pro-rate their contribution limit. Also, individuals may be able to make a once per lifetime trustee-to-trustee IRA to HSA rollover (known as a “qualified HSA funding distribution”) without incurring any tax or penalty, though this amount will count towards their yearly contribution limit, and they should consult their tax advisor before doing so.

Much like IRAs, the yearly contribution deadline for an HAS is generally April 15^th of the following year.

Employer vs. Employee Contributions

HSAs are “portable” accounts, much like an IRA, that you can take with you from employer to employer, and can be opened individually by taxpayers at a variety of institutions. Certain institutions (such as Fidelity Investments) currently offer the account free-of-charge and may not charge trading commissions.

Unlike other portable accounts, however, employers have the option of providing the account to the employee, and making direct contributions. In fact, there is a tax incentive for employers, rather than employees to make the contribution. Specifically, employer contributions may normally avoid FICA taxes, while employee contributions do not.

For example, let’s say that an employer covers its employees under a HDHP, pays them each $50K per year, and wishes to provide $2k for each employee’s medical expenses. It can either (1) increase their pay by $2k, or (2) contribute $2k directly to their HSAs.

In the first scenario, the employee will have taxable wages and FICA wages of $52,000 for the year. Assuming they turn around and contribute the $2K to their HSA, they will get a deduction reducing their taxable wages to $50K. Their FICA wages, however, remain at $52K. Therefore, both the employer and employee will have to pay 7.65% in FICA taxes on the entire $52,000.

In the second scenario, the $2,000 contributed directly to the HSA is deductible to the employer, not to the employee, but is never included in the taxable or FICA wages of the employee. The non-inclusion in FICA wages means the employee saves an additional $153 (7.65% * $2,000) in taxes, with the employer also receiving a reduction in FICA taxes.

It is therefore generally preferable that the employer makes direct contributions. The additional benefit, however, is reduced with respect to employees who will not pay Social Security taxes on additional wages (i.e., for 2020, those making above $137,700), though the benefit would still apply with respect to the 1.45% Medicare tax.