Why You Should Consider an HSA Even With a Lower Salary

If you’re looking into tax-advantaged ways to save money, you need to consider a health savings account (HSA). An HSA has a unique triple tax benefit. Your contributions reduce your taxable income, any investment growth within the account is tax-free, and qualified withdrawals (that is, ones used for medical expenses) are tax-free.

And unlike with the flexible spending account that many businesses offer their employees, any money left in your HSA account doesn’t disappear at the end of the year. It rolls over into the new year.

How HSAs Work

To be eligible to contribute to an HSA, you must be enrolled in a high-deductible health plan. That means a plan with a deductible of at least $1,400 for an individual or $2,800 for a family.

If you have that type of plan, you’re eligible to open an HSA. The amount you can deposit is adjusted from year to year. For 2021, you can contribute up to $3,600 for individual coverage and up to $7,200 for family coverage. For 2022, the limits are $3,650 for individuals and $7,300 for family coverage.

People age 55 and older can make catch-up contributions of $1,000 per year. They will have to do this in separate accounts. Joint HSAs are not permitted.

Any money left unspent in the account money rolls over year to year. If the account earns interest, the earnings are tax-free.

Some employers contribute a portion of the amount paid into the employee’s account. The maximum contribution remains the same in that case.

If You Sign Up Mid-Year

These numbers assume you sign up for the HSA at the start of the year. If not, the math is simple.

Annual contribution amounts are prorated for people who join the plan after Jan. 1 of any year.

If you sign up later in the year, divide the annual contribution limit by 12. Then, multiply that amount by the number of months you are eligible for the plan. An individual who joins a plan at the end of June 2021, for example, would be able to contribute $1,800 (half the yearly amount of $3,600)—or six months multiplied by $300.

The Last-Month Rule

There is a way to contribute the maximum even if you are eligible for the plan for less than the full year under the so-called “last-month rule.” According to the Internal Revenue Service (IRS), if you are eligible for a plan on the first day of the last month of the tax year (Dec. 1 for most people) you are considered eligible for the entire year. By that rule, you could contribute up to the top limit.

But there is a sticking point. If you use the last-month rule to contribute more than the prorated amount, you must remain HSA-eligible for that month as well as the following 12 months. Otherwise, you’ll have to pay income tax on your contribution amount and pay a 10% penalty on the money (unless you become disabled or die.)

HSA Contribution Limits
Individual Family
2021  $3,600  $7,200
2022   $3,650  $7,300

Taking the Tax Deduction

The entire amount deposited is tax-deductible on returns for that year, even for filers who do not itemize deductions.

Contributions by an employee directly from paychecks are made with pretax dollars, reducing their gross income. Employer contributions are deducted from taxable income by the employer, so they do not need to be itemized by the employee.

Using the Money in the Account

Funds in the account can be used to pay for a wide-ranging list of qualifying healthcare expenses. These include prescriptions, doctor visit copays, mental health and addiction treatment, dental care, and vision care.

The list also includes the costs of alternative healthcare treatments such as acupuncture or chiropractic services. Fertility treatments, smoking cessation programs, service animals, and long-term care insurance premiums all are covered, as are many health-related products.

The IRS periodically updates its list of the allowed (and not allowed) expenses in IRS Publication 502 has the current list and most insurers provide their customers with one.

Note: You can withdraw money from your HSA account for any reason. It’s your money, after all. However, if the expense isn’t on the IRS-approved list and you’re not at least age 65, you’ll owe taxes and possibly a 20% penalty for the withdrawal that year.

No Expiration Date

Unlike flexible spending accounts, HSAs have no use-it-or-lose-it deadline. The money rolls over into the following year. The account is portable and stays with an individual if they change jobs.

This makes the HSA a great savings vehicle even for the youngest and healthiest people, who may face increasing expensive medical care in future years.

A bonus benefit is that the account owner, after the age of 65, may take distributions from the HSA for any purpose, health-related or not. They will pay regular income tax but no penalty on withdrawals for non-medical costs.

The Advantages of an HSA

HSAs stand to benefit many taxpayers, especially in light of the fact that a typical couple turning 65 today will pay an average of $300,000 in out-of-pocket medical costs during their retirement years, according to a 2021 study by Fidelity Benefits Consulting.

With that in mind, investing the money in the HSA account may be the best course.

Money In Your Account Can Be Invested

Account-holders who invest some of the assets in their accounts tend to have significantly higher average balances, according to the Employee Benefits Research Institute (EBRI)—$22,496, compared with $2,296 for non-investors. Investors also had higher contribution amounts than non-investors ($3,619 and $1,495).

A 55-year-old who contributes the maximum amount to an HSA every year until age 65 could see a balance of $60,000 from total contributions of about $42,000, assuming a 5% rate of return, the EBRI notes.

An aggressive, high-earning 45-year-old saving the maximum, including catch-up contributions when eligible, could see a balance of $150,000 at age 65. If the rate of return is 7.5%, which is feasible, the balance rises to $193,000.

Of course, an HSA is not intended primarily as a retirement savings vehicle. It’s there so that you can cover out-of-pocket medical costs from year to year. But it’s worth considering, as each unexpected medical bill arrives, whether you should tap into your HSA or leave it for a possible greater need down the road.

Tax Savings Every Year

Millennial entrepreneurs take note: An HSA owner in the 28% tax bracket who began at age 25 and earned 7.5% on the account over time could have saved nearly $350,000 in federal income taxes alone, not to mention state taxes or other payroll taxes.

Another big advantage is the savings on medical expenses. Let’s say you earn $50,000 at a 36.40% tax rate. You’d have to earn $4,716 to pay for a $3,000 medical procedure such as laser eye surgery, but just $3,248 if you use an HSA. (Note that HSA contributions are generally subject to state tax.) That’s a savings of $1,468.

If you are at least age 65, you can withdraw money from your HSA for any reason without taxes or penalties.

Who Benefits Most From Having an HSA?

The short answer: nearly everyone. You don’t need a high income to benefit from an HSA, says Carolyn McClanahan, a certified financial planner and founder of Life Planning Partners in Jacksonville, Fla. Even if you’re unable to contribute the maximum amount allowed, “there is value in putting anything away, and little savings add up,” McClanahan says.

This is especially true for younger people, she notes, since getting into the habit of taking advantage of an HSA can be a good way to form good savings habits.

Something to keep in mind, McClanahan says, is that high-deductible health plans, which you must have in order to be eligible for an HSA, have changed a lot. “The copay plans used to be a better deal, but now I think they’ve constructed them so they’re not,” she says.

Even a person with significant health issues might find that a high-deductible plan, coupled with the ability to save tax-free in an HSA, is a better deal. “Where people get into trouble is if they have a really high deductible [they can’t meet].” In that case, they need to either save up that money in the HSA or choose a plan with a lower deductible.

This bracket ended in 2018. The closest current tax brackets are 24% and 32%; savers would garner more or less than the example above.

Choosing an HSA Administrator

If you don’t have an HSA through an employer, you can open your own account through many financial institutions. The options have improved over the years, so you can shop around for the best HSA administrator for you.

That means an institution that offers investment options that match your risk tolerance.

Even if you’re self-employed, you can reduce your taxable income by paying health insurance premiums out of pocket and saving the HSA funds for the future.

Who Benefits Least From Having an HSA?

People who have a lower income can benefit from having an HSA, if they can manage to stash at least the amount of their insurance deductible in the account.

McClanahan recommends funding the account every year. “If you don’t use it, it builds up,” she notes.

If money is really tight, you need to run the numbers. If your health insurance costs are subsidized through a state or federal Affordable Health Care Exchange website, you may not have an urgent need to save even more for your health care costs through an HSA. Those subsidies are even more generous, at least temporarily, through the American Rescue Plan passed in response to the COVID-19 pandemic.

The American Rescue Act increases premium tax credits for all income brackets for coverage years beginning in both 2021 and 2022. Most people across all household income levels will see lower premiums as a result of receiving more tax credits to reduce plan prices.

The factors to input into a calculator are the cost of premiums, compared with those of a lower-deductible plan with higher premiums; whether your employer is contributing anything to the HSA—that’s free money—and the total of any regular, expected healthcare costs, not including annual wellness visits and preventive care, which carry no cost in a high-deductible plan.

Some Affordable Care Act plans are not HSA-eligible: The plan will state whether it can be used with an HSA.

You can withdraw money from your HSA for any reason, but if it’s not to cover an approved healthcare cost you’ll owe income taxes and a 20% penalty. You shouldn’t use it lightly, but it is your money.

Health Savings Account Q&As

How Does an HSA Tax Deduction Work?

If you get an HSA through an employer, the employer will handle the tax paperwork. Your payments into the account will be deducted from your gross income, reducing the amount of federal taxes you pay.

If you get an HSA on your own, you can take the deduction when you file your income tax return. You don’t need to itemize deductions to get it. It is recorded on Form 8889 and included with your Form 1040.

If you invest the money in your HSA and earn interest on the account, that money is not taxable.

How Do I Get Reimbursed from an HSA Account?

The short answer is, send in a receipt to your HSA provider and you’ll get reimbursed for the expense.

There are many companies offering HSA accounts, and their procedures vary. The best HSA providers make it easy for you to open an account, pay money into it, keep on top of your available balance, and get money out of it.

How Can I Make Sure an Expense Is Covered?

IRS Publication 502 has the latest list of medical and dental expenses that are covered in an HSA, plus a list of expenses that aren’t eligible. (The list of eligible HSA expenses is basically the same as the list of medical expenses that are tax-deductible for those who itemize.)

Your HSA provider will have its own list.

Can I Use My HSA to Pay Family Medical Expenses?

Yes. The money is available for medical expenses incurred by you, your spouse, your children, and any other dependents you claim on your federal tax return. They don’t even have to be covered by your health insurance plan.

If a Family Member Contributes to an HSA, Who Gets the Tax Deduction?

The account holder is the owner of the account and is responsible for making the contributions and getting the reimbursements. That person takes the tax deduction, whether an individual or a family is covered by the plan.

The Bottom Line

Even if you’re maxing out your 401(k) plan or IRA contributions, you shouldn’t ignore the advantages of saving a bit more on taxes in a health savings account.

That triple tax advantage makes it an excellent choice for putting away a bit of money for your health-related needs. You can use it immediately if you need to, or you can let it grow into a tidy sum for your retirement years.

As they have grown increasingly popular, many more options are available, especially for people who want to invest the money in order to add some tax-free profits to their healthcare nest egg.

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