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HSA Tax Benefits: How to Make the Most of Your Account

Oct 14, 2020 4 min read Rebecca Lake

Key takeaways

  • Contributing to a health savings account can yield a trifecta of tax breaks.
  • Your HSA money can grow tax free until you need it.
  • You may be able to invest your money in mutual funds or other investments.

 

Health savings accounts (HSAs) offer a tax-advantaged way to save for future health care expenses. These accounts, which are offered along with high-deductible health plans (HDHPs), can be a great perk as part of your employee benefits package or if you have self-employed health insurance coverage. And you can fund them with pretax dollars if you contribute by payroll deduction.

 

 

If you're not fully utilizing your HSA, however, you could be missing out on some valuable tax benefits. Here are three important reasons to consider fully funding your HSA if you're not doing so already.


Tax benefit #1: HSA contributions can be deductible

Deductions can be your best friend from a tax perspective. Deductions reduce your taxable income for the year, which can potentially lower your tax bill or increase your refund.

Similar to 401(k) or individual retirement account (IRA) contributions, the money you save in an HSA is tax deductible, up to the annual contribution limit. That limit depends on whether you have an individual or family health care plan: for 2020 and 2021, $3,600 for individuals and $7,200 for families. An additional "catch-up" contribution of $1,000 is allowed if you're 55 or older.

The higher your income, the greater the tax benefit you stand to gain by maxing out your HSA contributions. Under the 2017 Tax Cuts and Jobs Act, someone in the top tax bracket would save about $2,500 a year by contributing the full HSA limit with family coverage.

Here's something you may not know about HSAs: your employer can help out with deductible contributions. If your employer offers an HSA match, that means you have to contribute less out of your own pocket to get the deduction. Just remember that the total amount you and your employer contribute can't be more than the annual contribution limit.

 

Tax Benefit #2: HSAs can create tax-deferred growth

When you save in an HSA, you may have the option to invest your money in mutual funds or other investments, versus leaving it in cash. While cash is safe, investing in the market can yield higher returns. And the money you invest grows tax-deferred over time.

Someone who's 35 years old with family coverage could see their HSA grow Opens in new window to more than $450,000 by contributing $6,900 per year for 30 years. That's assuming a 5% return on their investments (positive returns are not guaranteed). The total amount of tax savings realized on that growth could be over $50,000.

Unlike a flexible spending account (FSA), HSAs aren't "use it or lose it." And unlike a traditional IRA or 401(k), there are no required minimum distributions (RMDs) once you reach age 72. That means that you can leave your savings alone indefinitely. If you stay healthy and your HSA investments enjoy solid returns, you can carry all of that tax-deferred growth with you into retirement.

 

Tax benefit #3: HSA withdrawals can be tax free for qualified medical expenses

While you can enjoy tax-deferred growth with a 401(k) or traditional IRA, you do eventually have to pay taxes on the money. Once you start making withdrawals in retirement, ordinary income tax kicks in.

That's not the case with an HSA. When you use HSA funds for qualified medical expenses, the entire withdrawal is 100% tax free.

So which expenses are eligible for tax-free HSA withdrawals? The list is quite broad and includes things like:

  • Chiropractic services
  • Coinsurance payments
  • Dental treatment
  • Eye exams, eyeglasses and contact lenses
  • Hearing aids
  • Hospital services
  • Laboratory fees
  • Physical exams
  • Prescription drugs
  • Weight-loss programs
  • Wheelchairs
  • X-rays

If you're worried about a serious health issue adding to your medical costs later in life, you can also use your HSA savings tax free to pay for long-term care insurance premiums.

 

What about nonmedical expense withdrawals?

Technically, you can withdraw HSA funds at any time, for any reason. But there's a catch for withdrawals that aren't related to medical care.

If you're under 65 years old, any withdrawals you make from an HSA that aren't used for qualified medical expenses are subject to a 20% tax penalty. You'll also owe ordinary income tax on the withdrawal.

There is, however, an upside. Once you turn 65, the 20% penalty goes away. You can then take money out of your HSA for any reason and only pay regular income tax on the withdrawal. While an HSA isn't a retirement savings account, it can add to your retirement savings if you anticipate staying healthy over the long term.

 

Coordinating HSA tax benefits with Medicare coverage

Once you enroll in Medicare Part A and/or Part B, you can no longer make new contributions to your HSA. You could still be enrolled in your high deductible health plan and Medicare at the same time, but you'll lose the tax benefit of tax-deductible contributions.

You could delay your Medicare enrollment temporarily if you want to continue saving in your HSA so you can take advantage of the deduction. If you decide to delay Medicare, you'll need to stop contributing to your HSA at least six months before you plan to enroll. Once your Medicare coverage takes effect, it applies retroactively and any overlap between your coverage and HSA contributions could trigger a tax penalty.

 

 

What you can do next

Check with your HSA administrator to see how much you're contributing to your account each year and whether an employer matching contribution is available. If you're closer to retirement, consider where HSA withdrawals fit into your plan for spending down tax-advantaged savings.

Footnotes

 

Please consult your tax advisor regarding your particular circumstances.

Rebecca Lake has been covering finance, investing, and small business for nearly a decade. Her work has appeared online at U.S. News & World Report, MSN Money, Business Insider, and Investopedia.

 

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