Health insurance is one of the major issues in the modern world, and the election in the next few months will no doubt create more conflict. While there are many financial planning topics that help you interact with health insurance and healthcare expenses, having access to a Health Savings Account may be one of the most advantageous. These accounts are one of the few times Congress allowed money to essentially stay tax-free forever. If done correctly, it is possible that you could never pay taxes on medical expenses again.
What is an HSA?
A health savings account (HSA) is a form of savings account specifically for medical expenses. Similar to other “single purpose” financial planning tools, HSAs exist specifically to help cover the thousands of dollars spent on healthcare each year. The IRS has defined rules around the account, but the premise allows individuals to contribute to the account and let the account grow until it is needed to pay off bills and other expenses. No one specifically hopes to have to pay for healthcare in the future, so having a dedicated savings account can better support your overall financial picture.
Commonly, business owners and businesses will offer health insurance that provides access to these HSAs. From an employee perspective, to qualify for an HSA account, you must enroll in a high-deductible health plan (HDHP). Each year, the IRS sets both a minimum deductible limit and a maximum out-of-pocket limit for health insurance plans. If your plan meets both requirements, then your plan would likely qualify.
It could become more complex if your spouse has a covered plan. For example, a self-employed business owner who is covered by a spouse’s non-HDHP is not eligible for an HSA. Married couples with access to multiple health insurance plans need to understand each of the insurance policies they have access to and determine which is best for their family’s needs. For 2024, each person can contribute $4,150 for self-only HDHP coverage and $8,300 for family coverage. Look at your current policies to make sure that you are within these bounds and speak to your insurance agent if you need help.
How an HSA Works
Contributions to an HSA are advantageous because an owner can contribute to their personal HSA (and their employee’s HSA) and claim a business deduction for the compensation paid out. Similar to a retirement account, contributions can reduce overall payroll and personal taxable income. For example, Sole Proprietors and single-member LLCs would contribute after-tax dollars before including the deduction on next year’s tax return. Depending on the structure of your business and whether employees are relevant, it could change how the contributions are recorded and deducted. It’s best to check with your accountant so they are done correctly.
From a tax perspective, HSAs have a triple tax benefit of deductible contributions, tax-free growth, and tax-free distributions for qualified expenses. When compared to traditional accounts like a 401k or IRA, the triple tax benefit is very powerful. For example, a typical 401k will allow deductible contributions and tax-free growth, but all distributions would be taxable. In Roth-style accounts, the reverse is true (taxed contributions, tax-free growth, tax-free distributions). Since it is possible that all three phases are not taxed, an HSA can turn into a “never-taxed” savings account.
As a result, most HSA owners will fund their HSA each year and invest the contributions. As the account grows each year, they can periodically distribute chunks of the account as medical expenses come up. Since the HSA is almost an extension of your health insurance, you can use your HSA for many healthcare expenses that you or your family face. As of 2022, the average national health expenditure per person rose to $13,493. For owners in a 30% tax bracket, using their HAS could mean an average tax savings of $4,047, each year.
Tradeoffs of an HSA
Health savings accounts are a great way to save for future medical expenses. Going down the route of an HDHP and an HSA does have its risks. When moving from a non-HDHP, the joy of decreasing the premium of your policy still means your deductible will increase. While that may mean less monthly expense for health insurance, that does mean less is covered by insurance when it is needed. If you and your family are relatively healthy, the trade-off could pay off and in turn use an HSA to create tax-free wealth for the future. On the other hand, those with a lengthy medical history may not benefit from the additional risk of an HDHP and/or an HSA.
Any money that you put into an HSA should be earmarked to pay for health expenses. The IRS has a 20% penalty for distributions that do not qualify as healthcare expenses. Fortunately, the IRS drops the penalty once you reach age 65. From age 65 on, the account turns into something like a hybrid IRA, where distributions for medical expenses are tax-free and non-medical distributions are just taxed as income. Chances are by the time you reach your 60s and 70s, you will have more medical bills anyway, not less.
The reason why HSAs are so popular as a long-term savings tool is that you can use funds to reimburse yourself for medical expenses. There is currently no timeline before an expense is “too old” and cannot be refunded. Taken to the extreme, as long as someone could prove the paid expense (i.e. with a receipt), they could stockpile a life’s worth of family medical receipts and take out all of the money in the HSA tax-free once they hit retirement. The most common objection to the HSA is putting “only” a few thousand in each year would not make a difference. Well, this strategy allows that few thousand dollars of contributions each year to compound for decades and could result in a 6-figure tax-free account.
The Future of Your Healthcare
HSAs can be a great financial planning tool to use in the future. The maze of healthcare options, insurance policies, and medical expenses will never end. HSAs on the other hand, allow us to take some control and plan for expenses that are likely to happen. With nearly everything in life, there are tradeoffs to enrolling in an HDHP and setting up an HSA. Talk with your professionals, but if done correctly, it could mean the difference of thousands of dollars in taxes.
TC Falkner 