Now that you’ve chosen your 2019 health insurance, you may be able to benefit from one of the best tax breaks available: the health savings account. It pays to find out whether you’re eligible to contribute to an HSA and the three ways to maximize their “triple tax benefits.”
Under a high-deductible health plan (HDHP) — which requires a minimum deductible of $1,350 for an individual or $2,700 for a family in 2019 — you’re eligible to contribute to an HSA. But how exactly does that work? I recently described the insurance and tax factors to consider when choosing an HDHP. However, to take advantage of the HSA, there is a different set of decisions to consider.
The Benefits of HSAs
As a quick refresher, HSAs offer three major benefits for federal income taxes:
- Contributions reduce your taxable income without having to itemize deductions.
- Growth of the account is tax-deferred.
- Distributions for qualified medical expenses — for you and your family — are tax-free.
3 Ways to Maximize Your Tax Break
There are three ways you can maximize an HSA’s potential. The right choice depends on your situation.
- GOOD. Contribute the amount of out-of-pocket medical expenses you expect to incur in a year and use it as needed. With this option, you’ll get two of the three HSA tax benefits: deductible contribution and tax-free withdrawals. Since your balance would remain relatively small — and you may want to keep it in cash — you wouldn’t get much of the other benefit, tax-deferred investment earnings. There’s also an advantage of HSAs aside from taxes: Unlike with flexible spending accounts — which have use-it-or-lose-it rules — if you overestimate your expenses for the year, you won’t forfeit the balance.
- BETTER. Contribute enough to cover your expected medical expenses — and then some. Aim to build the account to completely cover one or more years of maximum out-of-pocket costs. Only draw on the account for large or unusual medical expenses, not the routine ones. Doing this helps you establish a reserve over time in case of a major health expense.
- BEST. Contribute at or near the maximum and invest most of it for the long term. This affords you the full triple tax benefit. For 2019, contribution limits are $3,500 (an increase of $50 from 2018) for individual coverage and $7,000 for family coverage (an increase of $100). With this approach, you should have an investment strategy for your HSA, just like you do for a retirement account. Because earnings in an HSA are tax-free if used properly, you may want to invest the HSA more aggressively early in your career. Leading up to and during retirement, you may want to shift your investments to a more conservative mix. Ultimately, you’ll want to draw down this account in retirement.
If you’re in a position to use this long-term strategy, the HSA can help cover significant expenses in retirement. Using tax-free distributions instead of tax-deferred accounts may also prevent you from jumping to a higher tax bracket or incurring higher Medicare premiums.
Costly HSA Mistakes to Avoid
The tax benefits of an HSA are great, provided the account is used appropriately. However, try to avoid:
- Using the account for nonqualified expenses. If you do this before age 65, there’s a double whammy: paying ordinary tax on the withdrawal plus a 20% penalty. That’s worse than the 10% early withdrawal penalties from retirement accounts. After age 65, withdrawals for nonqualified expenses result in paying ordinary tax on the amount. Tapping this account for non-medical expenses should be considered a last resort. Nonqualified expenses can range from the obvious (buying a boat) to a potentially surprising one — some health insurance premiums.
- Leaving a large balance to a non-spouse beneficiary. Upon the account holder’s death, the beneficiary will have to pay taxes on the balance in that same year. This could bump your beneficiary into a higher tax bracket. This is why it’s better to draw down the account in retirement to pay for medical expenses, as opposed to preserving it for your heirs. Fortunately, a spouse who inherits an HSA assumes ownership of the account and doesn’t pay tax on the balance.
A Few Final Tips
- Amounts contributed to an HSA via payroll deductions are generally not subject to payroll (FICA) taxes. So that’s usually the best way to contribute, especially if your wage income is under the threshold for Social Security taxes ($132,900 in 2019).
- That said, if you find you’re able to save more than you set up through payroll deductions, you can make additional contributions to the HSA on your own, up to IRS limits. As with an IRA, you have until your tax-filing deadline in April 2019 for 2018 HSA contributions.
- The HSA should not be considered your emergency fund, due to taxes and potential penalties on nonqualified withdrawals.
- While you can’t make additional HSA contributions once enrolled in Medicare, you can use the funds in the account to cover Medicare premiums, out-of-pocket expenses, and even a portion of long-term care policy premiums. However, Medicare supplemental policy (Medigap) premiums are not considered qualified expenses.
Don’t worry if you’re not currently in a position to save for the long term with your HSA. Using the account to cover your projected medical expenses is perfectly fine, especially if you have other financial goals like saving for a down payment on a home or for your kids’ education. However, saving in an HSA early can give you more options down the road to pay for health care expenses.
Roger Young is Vice President and senior financial planner with T. Rowe Price Associates in Owings Mills, Md. Roger draws upon his previous experience as a financial adviser to share practical insights on retirement and personal finance topics of interest to individuals and advisers. He has master's degrees from Carnegie Mellon University and the University of Maryland, as well as a BBA in accounting from Loyola College (Md.).
How to pick the best robo advisor for you
Kiplinger's guide to the best robo advisors to fit your needs.
By Kim Clark • Published
Stock Market Today: Microsoft Earnings Weigh on Stocks
While Microsoft reported top- and bottom-line beats in its fiscal Q2, shares declined on disappointing guidance.
By Karee Venema • Published
Want to Increase Income? Focusing on 5 Elements Can Help
There are multiple ways to generate income, but to make your money work for you, consider sustainability, maximizing, automation, reinvestment and tax efficiency.
By Jamie P. Hopkins, Esq., CFP, RICP • Published
Are Annuities Good Investments? Weighing the Pros and Cons
Love ’em or loathe ’em, annuities can be a smart investment tool for the right person under the right circumstances.
By Nate Miller, Investment Adviser Representative • Published
6 Questions Your Financial Adviser Should be Asking
To effectively help you with your retirement strategy, a retirement professional must get a clear picture of what you have and what you need.
By Tyler Hill, Investment Adviser Representative • Published
Financial Planning Should Be Intergenerational
Overcoming the unspoken rule that money is too taboo a topic to discuss among family members is important going forward. The reality is that families, at some point, will need to be on the same page about wealth planning.
By Aditi Javeri Gokhale • Published
In Retirement Planning, What’s Your Retirement Personality?
There are many ways to think about retirement planning, and your personality can influence yours. If your personality and plan match, you have a greater chance of retirement success.
By Samuel V. Gaeta, CFP® • Published
Inflation’s Toll: Cuts to Retirement Savings and Health Care
Many consumers struggling to make ends meet amid inflation are reducing retirement planning and health care, both of which can have disastrous results later in life. A professional could help.
By Kristi Martin Rodriguez • Published
Considering a Roth IRA Conversion? 6 Reasons It Makes Sense
Avoiding possibly higher taxes in retirement, having no RMDs and the markets being lower are just three reasons to switch to a Roth IRA.
By Kevin Webb, CFP® • Published
Am I Going to Be OK in Retirement? Yes, With Focus on 5 Key Areas
All it takes is protecting what you save, having an income plan, knowing your health care options, reducing your tax burden and making an estate plan.
By John Goodhue • Published