It’s open enrollment season, which means it’s time to review your health insurance alternatives. Have you considered your employer’s Health Savings Account (HSA) option? These tax-advantaged accounts may not be for everyone, but for many these programs offer several benefits.
To be eligible for an HSA, you must first be enrolled in a High Deductible Healthcare Plan (HDHP). According to Healthcare.gov, an HDHP must only cover preventative services before meeting the deductible and have a minimum deductible of $1,400 for self-only coverage or $2,800 for family coverage (2022 numbers).
So, what is an HSA? A Health Savings Account is an investment/banking account that is intended to pay for healthcare expenditures using pretax money. Contributions to the account are free of tax and can be withdrawn tax-free to pay for qualifying healthcare expenses. Examples of qualified expenses are:
•Doctors Visits •Vision Expenses
•Hospital Services •Long-term Care
•Dental Treatments •Prescription and Nonprescription Drugs
•Chiropractic Visits •Hearing Aids
The amount that can be contributed to the HSA is limited by IRS regulations. The maximum amount for 2022 is $3,650, and this amount includes both employee and employer contributions. There are also no income limitations, so HSAs are available to everyone as a potential tax-exempt investment account.
Now why would you choose to sign up for an HDHP and HSA, instead of traditional health insurance? In general, the traditional insurance is more applicable for low-income individuals and people with higher annual healthcare costs. Whereas, HDHP/HSA plans are generally more appropriate for relatively healthy, financially secure individuals and families.
The primary benefit of the HDHP/HSA is tied to tax savings. The higher deductible associated with the health plan can be offset by the tax savings realized in the HSA. HSA contributions provide a triple tax advantage:
- Contributions to the account can be made as pre-tax payroll deductions;
- Assets in HSA accounts grow tax free; and
- Withdrawals for qualified health expenses are also free of tax.
The payroll deduction contributions avoid both Social Security/Medicare taxes and income taxes. HSAs are pretty unique in excluding Social Security/Medicare taxes as contributions to qualified retirement plans (such as 401k or 457 plans) are still subject to those taxes. The bypass of Social Security/Medicare tax immediately provides a tax benefit of 7.65% of the contribution. When combined with income tax, the overall tax savings on HSA contributions is more than 20% to 30% of the contributed amount for most people.
The tax-free growth of HSA’s is another often-overlooked significant benefit. If you can pay for healthcare expenses using after tax money while allowing the HSA to grow tax-free, you can basically turn the HSA account into a tax-exempt retirement account. If you follow this strategy, you should keep records of your medical expenses as you can reimburse yourself free-of-tax at any point in the future for qualified healthcare expenditures that occur after establishment of the HSA. Let’s look at some examples.
Scenario 1
Say you contribute $3,650 in your HSA during 2022. You have $2,500 in qualified medical expenses in 2022 that you fully reimburse yourself for through your HSA. Let’s say this pattern continues for the next 10 years with the above numbers increasing each year at 3% inflation. Let’s also say you have a taxable investment account with $25,000 balance that you don’t need to touch for healthcare expenses as you are using your HSA. Over those 10 years, we’ll also assume that your investment accounts grow at 7%.
After 10 years, the after-tax value of your account balances will be:
Scenario 2
The situation is the same as above in all aspects except that the HSA contributions are not utilized to cover medical expenses. Instead, healthcare expenses of $2,500/year are paid out of the taxable account with a beginning balance of $25,000. The HSA account is allowed to grow tax free.
After 10 years, the after-tax value of your account balances will be:
The difference is almost $1,600, which is a benefit, although not very significant. Okay, so what if you are no longer eligible to contribute to the HSA but you let the both the HSA and taxable account continue to grow at 7% for another 20 years and continue to pay for healthcare in the same manner as identified for each scenario. If you deplete the account being utilized to pay for healthcare, you will start utilizing the other account to pay your expenses. After-tax account balances after this additional 20 years will be:
The difference is now apparent. The after-tax value of Scenario 2 is now $16,000 more than Scenario 1! Additionally, the assets in Scenario 2 are tax-free (if utilized for qualified healthcare expenses) and can continue to grow that way, whereas Scenario 1 assets are taxable.
To take a closer look at the initial tax saving characteristics of an HSA, let’s examine a third scenario where healthcare expenses are paid out of a traditional healthcare plan. Let’s say the traditional insurance will cover more of your medical expenses so that your annual expenditures are $2,000 instead of the $2,500 for the HSA. In this instance, though, you are no longer getting the benefit of using pre-tax dollars to pay for your healthcare. If you are in the 22% tax bracket, you will pay 22% income tax plus 7.65% Social Security/Medicare tax (29.65% total) on the earnings that you would have otherwise contributed to the HSA. After paying your taxes and healthcare bills, you invest whatever is left over in your taxable investment account that has a starting balance of $25,000.
Scenario 3
Annual investment = $3,650 x (1-.2965) – $2,000 = $568
Taxable Account After-Tax Value in 10 years = $53,800
The after-tax value of Scenario 3 is roughly $10,000 less than either of the previous scenarios after 10 years of implementation. In fact, healthcare expenditures would need to be only $1,400/year in order for the traditional health plan to come out even with the HDHP/HSA in this particular case! The HDHP/HSA may not always provide a better benefit than a traditional health insurance plan but, in this case with low healthcare costs, it sure produces a better alternative.
The decision to select traditional health insurance or to go with an HDHP/HSA is unique to each individual. The details of each plan can differ substantially between different employers and even within the Affordable Care Act Marketplace. In order to help offset the higher deductibles and in recognition of the lower policy premiums associated with HDHP’s, some employers also offer annual contributions into HSA accounts. These employer contributions can further tip the scales in favor of the HDHP/HSA, particularly considering that the funds are placed in a tax-advantaged account. A financial planner can help review each particular case to help determine which plan might be best for you.