Kiplinger published on January 5 an article by Kevin Webb, CFP, about using HSA accounts to fund retirement.
Déjà vu: Our July 5, 2016 Blog Discussed this Strategy.
When financial advisors write about retirement planning, their focus is usually on 401(k) & 403(b) plans, Individual Retirement Accounts (IRAs) – traditional and Roth, and perhaps non-qualified plans. How often are the overlooked HSA plans mentioned?
What is an HSA?
An HSA is a tax-advantaged way to save money to pay for qualified medical expenses. Generally, most HSA participants contribute the amount of anticipated health care costs they will incur for the year, and then withdraw funds from their HSA account to pay for those medical costs. At the end of the calendar year, if all goes as planned, the HSA account balance is zero as all the funds contributed to it (to lower taxable income) are withdrawn to pay medical expenses.
It is available for people who are covered by a high-deductible health insurance plan. While some high-income earners may find themselves ineligible for a Roth contribution or IRA tax deduction as their earnings exceed stated income ceiling thresholds, HSAs have no income limits on who can contribute.
What is a High Deductible Health Plan (HDHP)?
A HDHP has a higher deductible than a traditional insurance plan. The monthly premium is usually lower, but you pay more health care costs yourself (your deductible) before the insurance company starts to pay its share.
For 2022, the IRS defines a HDHP as any plan with a deductible of at least $1,400 for an individual or $2,800 for a family. An HDHP’s total yearly out-of-pocket expenses (including deductibles, co-payments, and coinsurance) can’t be more than $7,050 for an individual or $14,100 for a family. (This limit doesn’t apply to out-of-network services.)
Generally speaking, a HDHP best fits those with minimal health care needs. Whereas this group of individuals often dismiss health care coverage and opt to pay-as-they-go since they are healthy, it may be in their best financial interest to go with a HDHP and create an HSA account. As we generally incur more health issues as we age, it is all the more important to take full advantage of an HSA while you can.
HSA owners who wish to maximize the HSA benefits should be able to comfortably pay their medical expenses using after-tax dollars rather than reduce the HSA account balance to pay for those medical bills. The HSA retirement benefits are maximized by investing the contributions for growth and not withdrawing them right away for current medical costs. When they are withdrawn immediately, the account loses one of its three tax benefits (see below), as it is being denied the opportunity for tax-deferred growth.
The Triple Tax Benefits of an HSA
Unlike a flexible spending account (FSA) where the contributed funds have to be spent or are lost, HSAs allow account balances to roll over into future years. This makes HSAs an ideal long-term investment account (and medical retirement plan). HSAs provide:
- Tax deductions on contributions;
2. Tax-deferred growth; and
3. Allows Tax-free withdrawals if used for qualified medical costs.
Paradigm Shift Needed
Many taxpayers contribute the maximum they can to their 401(k) plan, and with any remaining money, they contribute that amount to an HSA. Perhaps a paradigm shift is needed. Contribute the maximum amount allowed by the IRS to the HSA and contribute the remaining funds to a 401(k) plan. While both 401(k) and HSA plans allow pre-tax contributions, the monies withdrawn from a 401(k) plan are subject to income taxes whereas HSA plans, if properly done, can have those contributions and earnings come out tax-free. If the HSA withdrawals are used to pay for medical expenses, they are free of income tax.
Another benefit of HSA plans are that they do not have any limitations on when a health care expense is incurred and when it is reimbursed. If you maintain those health care expenses that you incurred out-of-pocket while the HSA plan was in effect, you can reimburse yourself for those medical expenses many years later free of income tax. That’s right – tax-free income received in your retirement years. IRS Notice 2004-50 Q&A 39 discusses the rules that govern these distributions.
Unlike qualified retirement plans that dictate when you must begin to take distributions from those plans, there is no such requirement with an HSA plan. You decide when you wish to make those tax-free withdrawals.
Are Death and Taxes Certain?
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.
That is the case unless you make a gift of your HSA plan to a beneficiary who will then receive the same benefits that you enjoyed. While death can not be avoided, sometimes taxes can be avoided.
Tax Tip #1
We suggest you search HSA in the search box of our blog to read prior posts on HSAs and FSAs.
If you would like to discuss your business or personal tax planning, tax preparation and other financial 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.
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About F. Bryan Haarlander, EA, CTRS:
Bryan Haarlander is an IRS licensed Enrolled Agent and who owns and operates a specialized tax services firm serving clients in the western suburbs of Philadelphia, PA, which includes the cities of Chester Springs, Coatesville, Collegeville, Devon, Downingtown, Exton, Frazer, King of Prussia, Paoli, Philadelphia, Phoenixville, Pottstown, Radnor, Reading, Wayne, West Chester in Berks, Chester, Delaware, Montgomery and Philadelphia Counties, as well as clients in Delaware, New Jersey, New York and throughout the continental USA.
A Certified Tax Resolution Specialist, Bryan is well-known for his IRS tax resolution expertise and his book How to Resolve Your IRS Tax Debt Problems.