The Triple Tax Benefits of HSAs

About the author: Lamar Watson, CFP®, is a Fee-Only Financial Advisor in the Washington, D.C., area that works with clients virtually across the country. Lamar's work with his clients starts with a focus on budgeting, insurance, optimizing employee benefits, investing, and retirement planning. Dream Financial Planning is a Fiduciary Financial Planning firm specifically designed to help individuals in their 30s and 40s take control of their finances and fulfill their dreams. Feel free to schedule a complimentary consultation to learn how we use the DREAM Financial Planning Process ™ to help our clients achieve their goals. 

What Is a Health Savings Account?

Why do higher-income households inquire about Health Savings Accounts? They have heard about what an HSA can potentially offer them: a pool of tax-exempt dollars for health care, a path to tax savings, and even a possible source of retirement income after age 65. You may want to look at this option yourself.

An HSA can be used to save for future medical costs. They tend to have multiple tax benefits, including:

• Pre-tax income is deducted from your paycheck, lowering your total taxable income.
• Your HSA balance grows tax-free.
• The IRS won't tax money you withdraw to pay for medical expenses.

IRS Announces Spike in 2023 Limits for HSAs and High-Deductible Health Plans

How Do I Qualify for an HSA?

You must enroll in a high-deductible health plan (HDHP) to have one, a health insurance option that is not ideal for everybody. You fund an HSA with tax-free contributions. Some employers will even provide a matching contribution on your behalf. Not only do these plans offer a tremendous tax benefit, they also serve as another avenue for retirement savings.

These accounts offer a win-win situation by balancing today’s savings and planning for the future. In exchange for lower premiums, an HDHP has higher deductibles. If you have large unforeseen medical expenses, you may have sizeable out-of-pocket expenses. In addition, you can not:

• Be claimed as a dependent on the previous year’s tax return.
• Have Medicare.
• Have any other health coverage, aside from certain exceptions as outlined by the IRS.

What qualifies for a high-deductible health plan?

For 2023, the IRS defines a high-deductible health plan as any plan with a deductible of at least $1,500 for an individual or $3,000 for a family. An HDHP'S total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) can't be more than $7,500 for an individual or $15,000 for a family

HSA Pros

The tax advantages of an HSA are as follows:

1. Contributions to an HSA are pre-tax or tax-deductible. Just like a 401(k), 403(b), or IRA.
2. Earnings grow tax-deferred. Just like a 401(k), 403(b), or IRA.
3. Withdrawals for eligible medical expenses are tax-free.
4. HSA contributions can remain in your account to be used for future medical bills at any time.

Can I Make A Deductible Contribution To My HSA?

HSA Cons

In order to qualify for an HSA, you must have an HDHP (high deductible health plan). This doesn't work for everyone, particularly those with high healthcare costs.

Potential Penalties

When using HSA funds for non-qualified medical expenses before age 65, you’ll owe tax plus a 20% penalty.

Contribution Limits

Maximum contribution amounts for 2023 are $3,850 for self-only and $7,750 for families. The annual “catch-up” contribution amount for individuals age 55 or older will remain $1,000.

Tax Savings

HSAs offer you three potential opportunities for tax savings. Your account contributions are tax-free (that is, tax-deductible), the earnings in your account grow tax-free, and you can withdraw funds from your HSA, tax-free, so long as they are used to pay for qualified health care expenses, such as deductibles, co-payments, and hospitalization costs. (HSA funds may not be used to pay health insurance premiums.)

Will The Distribution From My HSA Be Tax & Penalty-Free?

HSA Tax Benefits. A large draw for many are the tax benefits inherent to HSAs:

• Contributions through an employer are always pretax
• You can invest the funds after your account balance reaches a certain level
• Distributions for qualified health expenses aren't taxable

Retirement Income

At age 65, you can even turn to your HSA for retirement income. Current federal tax law allows an HSA owner 65 and older to withdraw HSA funds for any purpose, penalty-free. You can use an HSA to pay Medicare premiums (other than premiums for a Medicare supplemental policy, such as Medigap) or extended-care insurance premiums. No Required Minimum Distributions (RMDs) are ever required of HSA owners. Keep in mind, however, if you take a distribution that is not used for a qualified medical expense, the money may be taxable and a penalty could apply, depending on your age.

The Downside of Health Savings Accounts

Why is an HSA less attractive to some people? Well, the first thing to mention is the related high-deductible health plan. When you enroll in one of these plans, you agree to pay all (or nearly all) of the cost of medicines, hospital stays, and doctor and dentist visits out of your pocket until that high insurance deductible is reached.

If you are a senior (or a younger adult) with a chronic condition or illness, you may end up spending all of your annual HSA contributions and reducing your HSA balance to zero year after year. That works against one of the objectives of the HSA – the goal of accumulation, of growing a tax-advantaged health care fund over time.

Keep in mind that if you spend your HSA funds on non-qualified expenses before age 65, you may be required to pay ordinary income tax as well as a 20% penalty. After age 65, you may be required to pay ordinary income taxes on HSA funds used for non-qualified expenses. HSA contributions are exempt from federal income tax; however, they are not exempt from state taxes in certain states.

IRS Guidance

The Internal Revenue Service (IRS) or your HSA provider are great sources when getting started. In addition, the IRS offers an interactive assessment tool that can take the guesswork out of what qualifies as an HSA-friendly expense.

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