Too many young professionals are leaving Uncle Sam an enormous tax gratuity. How are they doing this? By not taking full advantage of the triple tax benefits of a health savings account. I've yet to meet anyone who wants to pay more taxes. Many do not mind paying their fair share, but they do not want to leave a tip.
An early to mid-career professional with a high-deductible health plan (HDHP) could be missing out on six figures of lifetime tax savings. With open enrollment for health insurance around the corner, it’s time to understand and utilize the benefits of your HSA.
What Qualifies as a High-Deductible Plan?
For 2023 a high-deductible health plan is defined by the IRS (opens in new tab) as one with a deductible not less than $1,500 for self-only coverage or $3,000 for family coverage, and for which the annual out-of-pocket expenses do not exceed $7,500 for self-only coverage or $15,000 for family coverage. Healthy young professionals are prime candidates for an HDHP. That is because many of them need minimal medical care; they visit the doctor annually and have no or few drug prescriptions.
Because their medical expenses are low, money contributed to a health savings account can be used to generate significant tax savings while also building a large health care nest egg.
What Are the Triple Tax Benefits of HSAs?
Contributing to a health savings account provides a triple tax benefit:
- First, anyone who contributes to an HSA receives a tax deduction. In 2023, individuals can set aside $3,850, and families can contribute up to $7,750. Any employer contributions are included in these limits, though. So, if your employer contributes $1,000, as a family, you can contribute $6,750.
- Next, if you invest your contributions — instead of sitting in cash — all the growth is tax-deferred.
- And lastly, when you pay for qualified medical expenses, distributions are tax-free.
One Couple’s $160,000 in Tax Savings
Here is an example of how a young professional couple can take advantage of an HSA:
Leia and Han will be 35 years old in 2023. They are married, both working, and have an adjusted gross income (AGI) of $225,000. They are covered by an HDHP under a family plan through Leia's employer.
Let us assume that Leia and Han contribute the maximum amount annually to their HSAs from 2023 until retirement 30 years later. We will also assume that their contribution limits increase by 1% a year. The account earns 5% a year, and they utilize the $1,000 catch-up contribution starting at age 55.
By age 65, Leia and Han would have well over $500,000 saved in their HSA. Between their yearly tax savings (federal 24%, atate 5%, and FICA 7.65%) on contributions and foregone taxes on the growth of the investments, they will have saved over $160,000 on taxes.
Let me say that again: They will have saved $160,000 in taxes by taking full advantage of their health savings account.
In this case, the triple tax benefits of pre-tax contributions, tax-deferred growth and tax-free withdrawals can be powerful. Unfortunately, most do not utilize their HSA to its full potential. According to the Employee Benefit Research Institute, (opens in new tab) average annual contributions were less than $2,000 per account, over half of account holders withdrew funds, and only 9% of accounts held investments other than cash.
How to Make the Most of HSAs
To maximize the benefit of HSAs, I recommend the following steps:
- Contribute the maximum amount to an HSA every year.
- Pay your medical expenses out of pocket, without tapping into the HSA to let it grow ad to possibly even use it as a retirement fund.
- Invest your HSA contributions into a diversified portfolio of stocks and bonds.
- Allow compounding to work its magic.
As a young professional, time is on your side. Days become months, and months become decades. Do not delay saving into your HSA. Start saving and growing your wealth while also prioritizing your health.
Matthew Broom is a wealth planner for CI Brightworth (opens in new tab), an Atlanta-based wealth management firm. He serves high net worth clients in the areas of retirement planning, investment management and comprehensive wealth advice. A former firefighter and paramedic, Matthew uses his real-world problem-solving expertise to develop customized financial strategies for the firm’s clients.
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