If you own a Health Savings Account (HSA), you likely contribute to the plan each year and then withdraw funds from the plan to pay for medical expenses. The benefit to you as an employee is that your contributions to the HSA are made from pre-tax dollars, thus reducing the amount of income taxes, FICA, Medicare taxes you pay. This is a great way to reduce the amount of taxes you pay.
But, is this a sound strategy for you and your family? Are you aware that you may be able to do much more with your HSA contributions?
Whereas most persons contribute the maximum to their 401(k) account and contribute “money left over” to their HSA, perhaps they would be better off doing the exact opposite. The strategy discussed below is assuming that your HSA allows investment options, just like your 401(k) plan does. If your employer’s plan does not offer investment options, share this blog with your employer and talk to your employer about finding a plan that does. If you are self-employed, you can easily move your HSA account to a different provider.
Here’s the strategy that may better fit your family’s needs. Remember, that a HSA account is a tax deferred investment strategy, just like your 401(k). The money contributed to the plan grows tax deferred. You may be thinking “How much can the fund grow in one year before I withdraw the funds to pay for medical expenses?” One needs a paradigm shift. Rather than withdrawing funds from the HSA to pay for medical bills, don’t touch your contributions! Let them grow tax deferred! (This is why investment options similar to 401(k) plans are needed.) In addition, you must be in financial position to pay for your medical bills with after-tax dollars.
Similar the thinking that goes with a 401(k) plan where the participant wishes to maximize contributions, the same thinking applies to an HSA if this strategy is adopted. Let’s look at the numbers for a family. The maximum 2016 contribution is $6,750. If the participant is age 55 or older, and addition $1,000 can be contributed. If the participant’s spouse is between the ages of 55 – 65, an additional $1,000 can be contributed to a separate plan. Thus under the current contribution dollar limitations, our case study can defer $8,750 every year between the ages of 55 to 65. That’s $87,500 being contributed into this plan ignoring the deferred earnings on the contributions. That can result in a sizable investment over time, especially for those who adopt this strategy early in their working careers.
Here’s another benefit. When you begin to make distributions from your 401(k) plan, those tax deferred contributions and earnings are subject to income taxes. Wouldn’t it be great if you could avoid income taxes? Well, if you make withdrawals from your HSA plan for non-medical reasons, those withdrawals are subject to income taxes also. BUT, what if you withdraw those HSA funds and use them for medical expenses? Those withdrawals are not subject to income taxes!! Thus if you compare the withdrawals of an HSA plan to those of the 401(k) plan, it would have made sense to maximize the HSA contributions in those early years.
And, the benefits continue. With a 401(k) plan, the government determines when you must make withdrawals from the plan. With an HSA plan, you can make the withdrawals whenever you desire. Wouldn’t it be great to make withdrawals, tax-free, at your discretion? The beauty of the HSA is that it allows you to reimburse yourself for medical expenses that you paid. Thus, you keep copious records of your medical expenses that you paid when you started the HSA plan, and your plan reimburses you for those “old” expenses. Yes, you can reimburse yourself for medical expenses paid years ago, dollar for dollar, and the IRS is not owed a single penny. IRS Notice 2004-50 Q&A 39 discusses the rules that govern these distributions.
What happens upon your death? Well, upon the death of the second spouse, the HSA becomes taxable compensation to the beneficiary who receives the HSA. Ouch! That hurts some, but don’t you despair. During your lifetime, you can make a gift of your HSA plan to a beneficiary who will then receive the same benefits that you enjoyed.
While this strategy may not fit everyone’s budget, for those who it does, they may find this of great interest.
If you want to discuss your business or personal tax planning and tax preparation concerns with an experienced tax professional, we invite you to call 610-594-2601 today to make an appointment at our Exton PA CPA office to discuss your situation. You can also schedule a consultation at Click Here.
