As you likely know, an HSA is your government-regulated health savings account, available to you if you have a high-deductible health plan. What you may not already know: Your HSA comes with some pretty major tax benefits and can be a powerful way to boost your retirement savings.
An HSA allows you to accumulate money on a pre-tax basis, and these funds can be invested and grow tax-deferred. If spent on qualified medical expenses, they can be withdrawn tax-free, too. The best of all worlds!
Here’s how it works.
Tax Advantage #1: Pre-tax contributions
When you use a payroll deduction to fund your HSA, your contributions will be made on a pre-tax basis. If, instead of using a payroll deduction, you fund an HSA with after-tax dollars, you’ll use those contributions as a tax deduction. Both options have the effect of reducing your taxable income.
Tax Advantage #2: Tax-free earnings
Your HSA can be invested very similarly to any other retirement plan. While the money is invested, there will be no 1099 report sent out each year. The reason? HSAs, like other retirement accounts, grow tax-deferred.
Tax Advantage #3: Tax-free withdrawals
Rather than paying taxes on the money you withdraw, which is the case with a 401(k) or IRA, you won’t be taxed when you withdraw funds from an HSA, provided you use them for qualified medical expenses.
If you withdraw money before you turn 65 for nonmedical expenses, you’ll pay a 20% penalty in addition to tax (withdrawals will be taxed at the same rate you would be taxed at for withdrawals from a 401(k) or traditional IRA). Note that after age 65, you are allowed to use the funds for nonmedical expenses without the 20% penalty, but you’ll still be taxed.
What are the contribution limits?
In 2020, that total is up to $3,550 for individuals, and $7,100 for family plans.
Are you older than 55 or turning 55 this year? You’re allowed to make catch-up contributions up to an additional $1,000.
Can I invest HSA funds?
Yes, you can invest in mutual funds, ETFs, stocks, or other investments, but it depends on your HSA provider. You’ll want to discuss the best route with your financial advisor or wealth manager, but, generally speaking, the way HSAs are treated from a tax perspective provides the potential for great investment growth and after-tax balance accumulation.
One potential strategy: Set aside the HSA funds that you anticipate needing for near-term medical costs, then invest the remaining HSA funds to strengthen your overall retirement savings.
Are you an employer?
Then you can also benefit. When you make contributions to your employee HSAs, you can save big on taxes as well, since you split the 15.3% FICA tax with your employees.
Other ways your HSA savings can benefit your financial and physical health in retirement:
- The funds in your HSA can roll over year to year; you don’t have to drain the account at the end of a calendar year the way you do with a flexible spending account (FSA).
- To maximize the power of HSA compounding, maximize your contributions and don’t withdraw funds unless you must; instead, use personal savings to pay for out-of-pocket medical costs.
- If you retire or lose your job prior to age 65, you can use HSA funds to pay for an employer-sponsored plan under COBRA, as well as healthcare premiums while receiving unemployment.
- Once you’re enrolled in Medicare, you’re not allowed to make contributions to an HSA. However, you are allowed to use your HSA to pay certain Medicare expenses.
- You can use your HSA to cover a portion of the cost of a tax-qualified long-term care insurance policy.
- Unlike 401(k)s and IRAs, there’s no required minimum distributions once you turn 72.
Interested in learning more about the health savings account (HSA) tax advantages, as well as other potential ways to minimize your tax burden as an individual or small business owner? Get in touch with us at Ironwood Wealth Management today.