Moving closer to year end, individuals will evaluate opportunities to reduce income tax exposure. While many are familiar with the tax benefits of IRAs and 401(k)s, one tax-favored account that is often misunderstood is the health savings account "HSA."
HSAs, if used effectively, can be a powerful tax planning tool. First, a few facts about the HSA.
Not everyone is eligible to contribute to HSAs. You must be on a high-deductible health insurance plan as defined by the IRS. High-deductible health plans have low monthly premiums in exchange for higher deductible and out-of-pocket limits.
You must also be under age 65. If you meet all other eligibility requirements, contributions made to an HSA may be tax deductible. Annual contribution limits apply and are $3,700 for individuals and $7,100 for families in 2021. Limits go up if you are age 55 or older.
Often confused with the flexible savings accounts "FSA," HSAs do not have a "use it or lose it" provision. You can carry the balance forward year after year, and if you change employers, you take the account with you.
As investors, the good news is that many HSA providers have investment options available in addition to cash accounts within the HSA.
The better news is earnings in the account grow tax-free and distributions are tax-free, if used for qualified medical expenses as defined by the IRS, which is a generous list expanded by the CARES Act including Medicare and long-term care insurance premiums.
With tax-deductible contributions, tax-free growth and tax-free qualified distributions, this triple-tax-free feature makes HSAs one of the most tax-efficient savings vehicles available.
When investing funds in the account, you must consider your risk tolerance and time horizon to access the funds, as you will be exposing the account to investment risks.
Despite the long-term tax benefits, many individuals still utilize the accounts for ongoing medical expenses before retirement due to the high cost of health care.
While this still affords you a tax benefit due to contribution deductions, you are shortchanging the potential tax benefits.
If you can pay for ongoing medical expenses from cash reserves and leave funds in the account to grow, the HSA can be used to build a pool of funds for health care costs in retirement that are, if properly utilized, never taxed.
Distributions not used for qualified medical expenses before age 65 would incur penalties. Once you reach age 65, you can access the account for any reason; however, distributions used for expenses other than qualified medical expenses are taxed as ordinary income, like IRA distributions.
With open enrollment around the corner, it may be worth a revisit of your anticipated health care needs and insurance options to determine if a high-deductible health plan and HSA combo is appropriate.
And as always, discuss with your financial adviser how the strategy might fit in your overall plan.