Why HSAs Appeal More to High-Income Earners
If you’re looking into tax-advantaged ways to save money, you may have been hearing about HSAs. A Health Savings Account, or HSA, is a savings account with a unique triple tax benefit. Contributions reduce taxable income, their growth within the account is tax-free, and qualified withdrawals (that is, ones used for medical expenses) are also tax-free. But one-size investment options rarely fit all. Would an HSA make financial sense for you?
How HSAs Work
To be eligible to contribute to an HSA, the taxpayer must be enrolled a high-deductible health plan, defined as a plan with a deductible of at least $1400 (individual) or $2,800 (family), by December 1st of the year (contribution amounts are prorated for partial year eligible taxpayers; these figures are for 2021). A single individual can deposit up to $3,600 in 2021. Taxpayers age 55 and older can make an additional catch-up contribution of $1,000 per year. For a family, the contribution limit is set at $7,200 for 2021. Joint HSA accounts are not permitted; each person must have his/her own account. Some contributions may be in the form of funds from the taxpayer’s employer—free money, in effect.
The entire amount deposited is tax-deductible on returns for that year, even for filers who do not itemize their deductions. Contributions by an employee directly from paychecks are made with pretax dollars, reducing their gross income. Employer contributions are deducted from taxable income by the employer, not itemized by the employee.
Funds in the account pay for healthcare expenses now or in the future. Withdrawals are not taxed so long as they are used for qualifying expenses, including alternative healthcare treatment (acupuncture or chiropractic services, for instance), prescriptions, doctor visit co-pays, mental health and addiction treatment, dental and vision care, smoking cessation programs, service animals, long-term care insurance premiums and many other medical-related goods and services. The IRS periodically updates the allowed expenses; see Pub 502 or check with your insurer for the most current list.
Unlike Flexible Spending Accounts, HSAs have no use-it-or-lose-it feature. The account belongs to the taxpayer and is not lost when the person changes jobs or does not use the funds before the end of the calendar year. Funds carry over from year to year, making HSAs a great savings vehicle for increasingly high medical bills that may occur in future years.
A bonus benefit is that after the age of 65, the account owner may take distributions from the HSA for any purpose, health-related or not; they will pay regular income tax, but with no penalty.
The Advantages of an HSA
HSAs stand to benefit many taxpayers, especially in light of the fact that a typical couple turning 65 today will pay an average of $280,000 in out-of-pocket medical costs before they die, according to a 2018 study by Fidelity Benefits Consulting. According to the Employee Benefits Research Institute (EBRI), a 55-year old taxpayer who contributes the maximum amount to an HSA every year until age 65 could see a balance of $60,000 from total contributions of about $42,000, assuming a 5% rate of return. Many major mutual fund HSAs achieve a 10-year rate of return that is significantly higher than 5%.
An aggressive, high-earning 45-year old saving the maximum, including catch-up contributions when eligible, could see a balance of $150,000 at age 65. If the rate of return is 7.5%, which appears to be entirely feasible, the balance rises to $193,000.
Millennial entrepreneurs take note: An HSA owner in the 28% tax bracket who began at age 25 and earned 7.5% on the account over time could have saved nearly $350,000 in federal income taxes alone, not to mention state taxes or other payroll taxes. (Note: this bracket ended in 2018; under the new tax bill the closest brackets are 24% and 32%; savers would garner more or less than the example above.)
Who Benefits Most From Having an HSA?
HSAs work best for big earners and those with high incomes. Why? First of all, as with any tax-advantaged investment strategy, you need to be in one of the high tax brackets to save significant money with a tax deduction.
Second of all, making those maximum contributions (the only way you’re going to reap that maximum growth in assets down the road) requires deep pockets – and not just because of the bite into your paycheck. HSAs work with a high-deductible health insurance plan, remember. That means if you are an individual holder (versus a family HSA holder) you need the ability to pay out-of-pocket at least $1,400 (and often a lot more, depending on the policy) in annual medical bills – before the insurance kicks in.
The key is to find a solid investment account for HSA funds. Many financial institutions offer HSAs, but not all of them invest funds aggressively or allow the account holder to have any control over how the funds are invested. An administrator is needed who can offer investment options that match the account holder’s risk tolerance. Self-employed individuals can further reduce taxable income by paying health insurance premiums out-of-pocket, saving HSA funds for the future.
Who Benefits Least From Having an HSA?
HSAs are not big money-savers for people in lower-income brackets. For starters, low-income families are unlikely to have the extra cash to tuck away in an HSA. Ironically, those who choose the least expensive Affordable Care Act plans are stuck with high deductibles anyway.
Let’s say that a 35-year-old Californian earning $25,000 per year went on the state’s Health Insurance Marketplace (aka “the exchange”) to buy an HSA-eligible Blue Shield Bronze plan with a $4,500 deductible for $143 per month. Or, perhaps that person opted for a Blue Shield enhanced Silver plan for $187 per month and reduced the medical deductible to $1,900. Since $25,000 is less than 250% of the 2018 federal poverty level for a family of one ($30,150), the individual would likely qualify for a Cost-Sharing Reduction subsidy which should reduce the monthly costs of coverage and help lower deductibles and other costs (you must purchase a Silver Plan to get this).
Middle-income families and those expecting significant medical expenses will also likely benefit by not going the high-deductible, HSA route. It takes numbers crunching to figure out what’s best.
The Bottom Line
“HSAs work best for people who are not eligible to buy [insurance] on the exchange,” says Craig Gussin, Medicare Co-Chair for the California Association of Health Underwriters. “Low-income taxpayers won’t save significant money every month; they give up cheap services without much savings. It all comes down to the numbers. HSAs work best for people over 50 on a group plan, with high income and no tax subsidy.”
Of course, a healthy person in any income bracket who expects to need little or no medical care during the year will always come out ahead by choosing the overall cheaper plan and banking the difference.
And while HSAs are good tax-advantaged vehicles, others are better. Financial planners agree that individuals should first max out 401(k) plan and IRA contributions for the year. Then, they can start funding an HSA, which will provide additional retirement benefits.