When the time comes to file and pay your taxes, it’s beneficial to know that you have taken advantage of every opportunity to reduce the amount of tax you owe and maximize your refund. A lot of people don’t do everything they can to save on their taxes and they end up paying the price on April 15th.
At CMP, a Utah CPA firm we understand that you want to minimize the amount of taxes you pay while managing your money responsibly. One of the questions we hear a lot has to do with Health Savings Accounts (HSAs):
What are the tax advantages of having an HSA?
HSAs are available to anybody who has a qualifying High Deductible Health Plan. It might surprise you to learn that there is a triple advantage to opening an HSA and using the funds in it to pay for medical expenses. Here’s what you need to know.
What is the Triple Tax Advantage of HSA?
Let’s start by reviewing the three tax benefits of opening and maintaining an HSA.
1. Contributions Are Tax-Free
The first tax advantage of HSAs is that your contributions are tax-free. You can make pre-tax contributions if you have an HSA through your employer. If you don’t, you can take a deduction when you file your taxes to reduce your taxable income. Also, keep in mind, that any contributions through payroll deduction are also not subject to payroll tax.
Best of all, you can take the HSA tax deduction even if you are taking the standard deduction and not itemizing. It’s a separate line item on Form 1040, so you can take advantage of it regardless of how you’re filing your income tax return.
2. Investment Growth is Tax-Free
The second tax advantage of HSAs is that growth on any investments made through your Health Savings Account is also tax-free. You can allocate your funds in any way you choose, and you won’t pay taxes until and unless you withdraw funds for something other than an eligible medical expense.
Keep in mind that the funds in your HSA roll over from year to year. There’s no requirement to use them, which means that you can take advantage of compound interest and growth while continuing to contribute funds (and reap the tax advantages) every year.
3. Withdrawals for Eligible Medical Expenses Are Tax-Free
The third tax advantage of HSAs is that you can take tax-free distributions provided you use the money to pay for eligible medical expenses. If you use the money for your medical costs, you will never pay taxes on it.
You can pay for a wide range of expenses using a tax-free withdrawal from your HSA. For example, you can pay for any expenses up to your annual deductible if you have a high-deductible health plan (HDHP), as well as office co-pays, coinsurance, vision care, dental care, and even over-the-counter medications. You can read the full list of eligible medical expenses in IRS Publication 502.
Other Benefits of Using an HSA Besides the Triple Tax Advantage
The triple tax benefit of HSAs might be enough to convince you that you need one, but there are additional advantages you should know about before you open an account.
HSAs Are Portable
While your flexible spending account (FSA) is tied to your employer along with any employer-provided health insurance, your HSA is flexible. You own the account and any funds in it, and even if you have made tax-free contributions through your employer, you can take the account with you when you leave.
It’s for this reason that we think it’s a better choice to have an HSA than it is to have an FSA.
HSAs Offset the Costs of High Deductible Health Plans
According to the Centers for Disease Control (CDC), the number of Americans enrolled in High Deductible Health Plans has been steadily increasing. It more than doubled from 2010 to 2017, and more than two-thirds of those have paired their HDHP with an HSA.
The reason is that you can use the funds in your HSA to pay for medical expenses that accrue to your deductible and out-of-pocket maximum, including copays and coinsurance.
Legislation Has Expanded the Uses of HSAs
In March 2020, the Coronavirus Aid, Relief, and Economic Security (CARES) Act expanded the use of HSA funds to include a variety of new expenses. These include the following:
- Telehealth appointments and services
- Over-the-counter medications
- Over-the-counter medical supplies
- Feminine hygiene products
Before the passage of the CARES Act, telehealth was covered only after an HDHP plan’s deductible had been met. Now, they are covered and may be counted toward the deductible.
HSAs Can Help You Pay for Medical Expenses in Retirement
Finally, HSAs can help you to pay for your medical expenses in retirement. According to a CNBC report from 2021, 36% of Americans believe that they will never have enough money to retire. Even some people who have retirement savings worry that they won’t be able to pay their medical expenses.
If you have an HSA, then the funds in it are yours to keep. You can allow them to continue to grow and dip into them as needed to pay for your qualified medical expenses, before or after you retire.
Are There Any Drawbacks to Using the HSA Triple Tax Advantage?
There are a few potential drawbacks to having an HSA, although we do feel that the advantages outweigh them. Here are the things you should keep in mind.
Funds in Your HSA May Not Be Used for Non-Eligible Expenses
You should be aware that while HSA funds may be used for many things, they must be used for eligible expenses if you want to avoid paying both taxes and penalties on your withdrawals.
Before you reach the age of 65, you will pay federal income taxes plus a 20% penalty for using the funds for ineligible expenses. After the age of 65, there is no penalty, but you will pay taxes on any withdrawals you make that you use for ineligible expenses.
You Need to Keep Careful Records
You are allowed to use the funds in your Health Savings Account for a variety of purposes, but you should not spend it on anything without keeping careful records. You’ll need to keep your receipts so that you can prove to the IRS that your expenditures were for qualified health expenses.
As a business owner or independent contractor, you need to save receipts. There are guidelines on how long to keep and which needs to be saved for tax purposes. Check out our blog post: Receipts for Taxes: Receipts You Should Keep for Taxes. Some suggestions on how to stay organized during the tax season are also included.
In the event you were to be the subject of an IRS or state audit, you might need documentation of your expenditures.
Your State May Tax HSA Contributions
While most states in the US do not tax contributions to HSAs, there are a few exceptions. People who live in California, New Jersey, or Alabama must pay state income taxes, so while HSA contributions are free from federal taxes, there is no deduction or savings in the three states we mentioned.
Of course, this exception doesn’t apply in states that don’t have a state income tax. In Utah, there’s a flat tax, and residents are not required to pay taxes on their HSA contributions. You should be aware that some states don’t tax contributions but do tax capital gains on HSA investments.
Some HSAs Charge Fees
This potential disadvantage doesn’t apply to every HSA, but some institutions do charge either a monthly maintenance fee or a transaction fee.
These fees are typically not high, but they may be more than the interest you earn on the funds in your account, especially at the beginning. Some fees are waived if you maintain a minimum balance in your account.
HSA Rollovers Can Be Complicated
The IRS allows the owner of any HSA to do a rollover to a new account. However, there are rules that you should know about. For example, you have only 60 days to deposit funds into your new HSA account before you will incur taxes and fees on your withdrawal from the original account
The rules for rolling over HSA investments are even more complex. These are seen as in-kind exchanges. If you need to do a rollover, your best bet is to work with an experienced financial professional to ensure that you don’t incur unexpected taxes and penalties.
Frequently Asked Questions About HSAs
Here are a few frequently asked questions about HSAs that we haven’t already covered.
How Much Can I Contribute to an HSA?
The IRS sets maximum contribution limits for HSAs. For 2022, the limits are $3,650 for an individual and $7,200 for a family HSA. If you didn’t have an HDHP for the entire year, you may still be able to contribute the full amount using the 13-month rule, which says that you must enroll in an HSA-eligible HDHP before December 1st of the given year and maintain your HDHP coverage through December 31st of the following year.
If you reach the age of 55 and you’re eligible for an HSA, you are allowed to make an annual catch-up contribution of $1,000 each year until you either turn 65 or become eligible for Medicare.
Can I Have More Than One HSA?
There is no limit on the number of HSAs an individual can have. However, you should know that the annual contribution limits are cumulative, meaning that if you open more than one HSA, you will need to spread your contributions out between your accounts and be sure they do not exceed the limit.
What If I Spend My HSA Money on Ineligible Items?
If you withdraw money from your HSA and spend it on ineligible items, then you will be liable to pay federal income tax on your withdrawals. You will also, as noted above, be hit with a 20% penalty on the amount you withdrew.
The penalty does not apply to those over the age of 65, but you will still be required to pay taxes on any withdrawals used for ineligible expenses.
How Can I Make Sure an Expense is Covered?
The best way to be sure that you are spending your HSA withdrawal on eligible healthcare expenses is to check IRS Publication 502.
The good news is that a wide array of treatments, services, and products can be purchased with the funds in your HSA, including everything from first aid supplies to guide dogs.
Can I Use My HSA to Pay Family Medical Expenses?
You can use the money in your HSA to pay family medical expenses for your spouse or dependents. The only rule is that the expenses must not be reimbursable elsewhere.
For example, if you are self-employed and have an HDHP for yourself while your spouse has separate coverage, you may not use your HSA to pay for expenses that your spouse’s insurance will cover.
Let Us Help You Take Advantage of the Triple Tax Benefits of HSA
The triple tax benefits of Health Savings Accounts can help people with High Deductible Health Plans offset their expenses and reap significant tax benefits. If you have an HDHP, then you may want to consider opening an HSA to take advantage of that.
Do you need help claiming the triple tax benefits of your HSA? CMP is here to help.