HSA Tax Deduction: How Your HSA Can Lower Your Taxes

Here at CMP, our mission is to assist our clients in maximizing their tax savings and reducing their tax bills. In light of this, it's important to understand how an HSA tax deduction can significantly lower your federal taxes.

What is a Health Savings Account?

A Health Savings Account or HSA is an account created by the Medicare Prescription Drug, Improvement, and Modernization Act, which was signed into law by then-President George W. Bush in December 2003. Health Savings Accounts were designed to allow participants to set aside tax-free money to pay for qualifying medical expenses. HSAs are typically administered by a financial institution such as a credit union or bank or by an insurance company, thus allowing the account owner to do several things at the same time:

• Save money for future medical costs on a tax-free basis.
• Earn interest in their contributions.
• Avoid accruing medical debt.
• Reduce taxable income.
• Save money on their income taxes.

You can take tax-free distributions of the funds in your HSA to be used for various expenses, including your co-pays, deductibles, preventive care, including annual physicals, prescription drugs, vision care, emergency room visits, and other medical and dental expenses. It may not be used to pay your insurance premiums.

Unlike flexible spending accounts, HSA contributions may be made by employers or individuals (including self-employed individuals) to pay for qualifying medical expenses. You are not required to pay regular income tax on HSA contributions or on the interest you earn on your HSA savings.

Health Savings Accounts are not available to everybody. We will talk more about qualifications in the next section, but HSAs are designed to help people with HSA-qualified HDHPs (high-deductible health plans.)

HSA Qualifying Rules and Limitations on Contributions

As we noted above, Health Savings Accounts are not open to everybody. You should know the requirements to see if you qualify for an HSA account.

1. The person who owns the HSA account must be 18 years of age or older.
2. The person who owns the HSA account must be continuously covered by a high-deductible plan. The definition of a high deductible health plan changes each year under IRS rules. For 2023 HSA-eligible plans, the annual deductible requirement is $1,500 for individual coverage and $3,000 for family coverage. 
3. The annual out-of-pocket medical expenses, which include co-payments, deductibles, and other amounts and exclude premiums, do not exceed $7,500 for individual coverage or $15,000 for family coverage.

There are benefits to having a high deductible health insurance plan, particularly if you and your family are in generally good health. Your insurance premiums will be significantly lower than they would be with a low deductible plan, and combining an HDHP with an HSA can help you save money on your taxes. You should consult with a financial advisor if you have high out-of-pocket costs.

In terms of contributing to an HSA, you should know about annual contribution limits as well. For 2023, the IRS has set the limits on annual contributions for HSAs as follows:

• A maximum contribution limit of $3,850 for individuals with self-only coverage and
• A maximum contribution limit of $7,750 for individuals with family coverage.
• HSA owners over the age of 55 may make an additional catch-up contribution of $1,000 per year.

Any excess contribution remaining in your HSA at the end of the year will automatically roll over into the next year, making it an ideal choice if you have concerns about being able to afford necessary medical treatments. Remember, contributions are made pre-tax, and withdrawals are tax-free. We'll talk more about that in the next section.

How Does a Health Savings Account Affect My Taxes?

There are several ways in which having an HSA can have a positive impact on your federal income taxes.

Are HSA Contributions Tax Deductible?

One of the most common questions about Health Savings Accounts is whether the contributions you make are tax deductible. 

If you make direct contributions to your HSA—meaning your HSA isn’t sponsored by your employer and contributions aren’t deducted from your pay—then the entire amount of your contribution is tax deductible. You don’t need to make an itemized deduction to claim the deduction for contributions.

If you have an employer-sponsored HSA where your contributions are taken via a payroll deduction and reduce taxable income by reducing box 1 of your W-2.

Additionally, HSA disbursements are tax-free, provided you use the funds for qualified medical expenses. You'll be taxed on your disbursements if you use funds for non-qualified expenses, including most non-medical expenses.

The interest you earn on your HSA balance is not taxable. You can roll any remaining contributions plus interest into the next year and withdraw funds when you need them.

Do You Need Earned Income to Contribute to an HSA?

What if you’re unemployed or retired? Can you still contribute to an HSA? Yes, if you’re not working or unemployed, you can still make HSA contributions, as having earned income is not a requirement.

Retirement contributions are dependent on whether you’re receiving Medicare benefits or not. If you’ve retired early and aren’t yet claiming your Medicare benefits, you may contribute to an HSA if you’re eligible and claim the same tax advantages as any other person. If you’re receiving Medicare benefits, you’re not eligible to have an HSA or make contributions.

Keep in mind that if you’re over 65, you can still withdraw existing HSA funds and use them for qualified medical expenses without paying taxes on your disbursement.

Reporting Your Health Saving Account on Your Taxes

Whether your employer makes HSA contributions on your behalf or you make them directly, you must report the HSA and all HSA contributions and disbursements to the Internal Revenue Service (IRS) using Form 8889. You may also use Form 8889 to calculate the amounts you must include in your reported income and to determine your HSA eligibility. If you are not eligible, your contributions will not be tax deductible.

Here are some important things to keep in mind when you complete Form 8889:

• If you started the year with an individual HDHP and transitioned to a family plan or vice versa, you must check the box that corresponds with the plan that you had for most of the year. In other words, if you had an individual plan for 8 months and then got married and transitioned to a family plan, you’d check the individual box on the form.
• Using the above example, your annual contributions and deductions would be determined based on the HDHP coverage you had on the first day of the last month of the year. For example, if you switched to a family HDHP in November, you’d be eligible to contribute up to $7,750 for the year plus the $1,000 catch-up contribution if you’re over the age of 55. Likewise, you’d be eligible for the tax break associated with a family account.
• If you started an HSA in November of a given year, you’d be eligible to make HSA contributions up to the annual limit and claim all related tax deductions and benefits. The same rule applies as noted above if you switched from an individual to a family plan.

The rules for reporting HSA contributions and disbursements are simple to understand, and they shouldn't complicate your federal income tax returns. The HSA deduction can help you reduce your regular income tax burden and make it easier to pay your qualified expenses.

Let Our Tax Professionals Help You Use HSA as a Tax Planning Strategy

Opening and funding a health savings account can be a cost-effective way to save money for medical bills for you and your family. It can save some money every tax year by reducing your taxable income and minimizing your federal income tax burden. Because the money rolls over and may be disbursed tax-free after you reach the age of 65, unused funds may also help you have a comfortable retirement.

Do you need help determining your HSA tax benefits? Click the button below. We're here to help!