As the dreaded tax season nears the April deadline, most taxpayers are now aware (in some cases, painfully) of the impact of the changes brought about by the Tax Cuts and Jobs Act. Each tax return has its own unique wrinkles, and few situations are the same. Still, one broad conclusion that has been made about the new law is the sharp reduction in the percentage of taxpayers who itemized deductions. It is estimated that more than 80% of filers will now use the standard deduction, which was nearly doubled from its prior amount ($24,000 for married couples, $12,000 for single filers). A direct result of this change is the benefit of deducting certain expenses has been reduced or eliminated for many people.
As less people itemize deductions, it’s as important as ever to take advantage of reductions to income still available. One common example of a reduction to income is traditional IRAs and/or 401(k) contributions. The merits of maximizing contributions to these retirement accounts are well known. But there is another under-the-radar and very effective tax-saving strategy that is often overlooked: the Health Savings Account (HSA).
Why is the HSA so valuable, especially for higher-income people? In short, because it is a rare “triple-advantaged” savings vehicle. By “triple-advantaged” we mean 1) contributions are tax deductible; 2) the account grows with no tax on capital gains, dividends, and interest; and 3) withdrawals are not taxed (subject to limitations described below). In addition, and of critical importance, it’s one of the few tax-advantaged accounts available to anyone, even those with higher income.
So let’s start with what HSAs are, the restrictions, and why we think they should be considered an additional means to boost retirement savings.
HSAs Defined: HSAs are individually-owned accounts that hold funds used to pay qualified medical expenses for the account owner. Contributions to these accounts are tax-deferred, which means all contributions reduce taxable income. If funds are withdrawn for anything other than medical expenses before age 65, the funds are taxed as ordinary income and may be subject to an additional penalty. When the account owner leaves their current job, they keep the account and all the funds in it. This is not a “use-it-or-lose-it” account.
HSA Eligibility: To be eligible to contribute to an HSA you must participate in a “high-deductible” health care plan with your employer. If you’re self-employed or self-insured you are subject to the same stipulation. For 2019, the health care plan must have an annual deductible of $1,350 for self-only coverage or an annual deductible of $2,700 for family coverage. There are also maximum out-of-pocket limits with the high-deductible plans, $6,750 for self-only coverage or $13,500 for family coverage.
HSA Contributions & Usage Restrictions: Account holders for self-only coverage can contribute and deduct $3,500 per year while family-coverage account holders can contribute $7,000 per year. If you’re 55 or older, you can add $1,000 to those amounts ($4,500 and $8,000, respectively). There are a few caveats:
- Any contributions from the employer reduce the taxpayer’s eligible contributions dollar-for-dollar. So if you are 55 years old with family coverage and your employer kicks in $2,000 to your HSA, you can only contribute $6,000 ($8,000 - $2,000).
- Account holders can coordinate contribution to other accounts such as an FSA (flexible spending account) with the key being the FSA must be limited purpose (dental and vision expenses) and cannot overlap. It is highly important to confirm with your benefits department before opening and contributing to multiple health savings vehicles, as these rules can get complicated.
- In general, you can use the funds any time for qualified medical expenses before retirement. Qualified expenses are unreimbursed medical expenses for the taxpayer, spouse, and dependents, including prescriptions. Health insurance premiums are not qualified unless the premiums are for COBRA, Long Term Care insurance, or if you’re unemployed.
The Math behind the Advantages of HSAs: After sorting through the red tape, we believe there are two substantial advantages to HSAs – both before retirement and during retirement.
- Before Retirement: As mentioned above, during the working years you can contribute funds to the accounts and save on your income taxes. For example, if you contribute $7,000 per year and you are married with over $200,000 of taxable income, you would save about $1,680 in taxes every year. Remember, under the new tax code a family at this income level has very few deductions available. At that level of income IRA contributions are not deductible. But the deductions for HSAs are not limited by income! And the fact that all of us will have at least some medical expenses somewhere along the line means it is highly likely tax-free withdrawals will be possible.
- During Retirement: One of the little-known provisions of the HSA is that when the account holder is eligible for Medicare (usually at age 65) they cannot contribute to an HSA, but they can withdraw the money and use it for any reason without the penalty. It is still taxable as ordinary income (like a traditional IRA distribution) but the ability to avoid the penalty means the HSA can act just like a tax-deductible IRA after age 65.
Bottom Line: With fewer deductions available than before, and some only available to those with lower income, any remaining deductions to income are worth consideration. If you have access to an HSA, and currently or will someday have medical expenses (won’t we all?), you should strongly consider making contributions to an HSA. Not only will you save on income taxes while working, but you’ll have another pool of money from which to draw in your retirement years.