Health savings accounts offer a triple tax benefit

Jeff Witz, CFP

One of the greatest benefits of being covered under a high-deductible health plan (HDHP) is the ability to contribute to a health savings account (HSA) and receive tax-preferred treatment on money saved for medical expenses. Specifically, HSAs provide a triple tax benefit. Contributions are made either pretax if offered through your employer or tax deductible if set up independently. Once in the HSA, a portion of the money is required to be kept in cash, but any amount exceeding that requirement can be invested. This investment can increase the balance of the account tax free. If the money is taken out of the HSA for a qualified health care expense, the contributions and the investment growth come out tax free. HSAs are an excellent way to pay for current and future health care needs on a tax-advantaged basis.

To qualify for an HSA in 2023, a HDHP requires a minimum deductible of $1500 for an individual or $3000 for a family. The plan must also have an annual out-of-pocket maximum of $7500 for self-coverage and $15,000 for family coverage. These maximums cap your out-of-pocket expenses.

An HSA is used to save money to pay for out-of-pocket medical expenses not covered by your health insurance plan, such as deductibles, co-pays, coinsurances, prescription drug costs, dental expenses, and vision care costs. Unfortunately, you cannot pay your monthly insurance premiums using an HSA unless you are 65 years or older and paying for your Medicare premiums. Premiums for Medicare supplemental or Medigap policies are not treated as qualified medical expenses.

The Internal Revenue Service recently announced an increase to the annual contribution limit for 2023. For a single individual on an HDHP, the maximum contribution amount is $3850. If more than 1 person is covered under the HDHP, the maximum contribution amount is $7750. There is a $1000 catch-up contribution amount if you 55 years or older. These amounts are tax deductible when reporting your taxable income.

Many employers offset a portion of your health care costs by making contributions to your HSA. Although you may not deduct any contributions made by your employer, those amounts are generally excluded from your gross income, meaning they are tax free. In addition, the contribution limits remain the same whether the contributions are made by you or your employer. For example, if your employer contributed $1000 to your HSA, the amount you may contribute and deduct is reduced to $2850 or $6750, not the full $3850 or $7750.

Contributions to your HSA can be made throughout the year or in a lump sum. If the annual contribution limit is not reached by year-end, you may continue to make contributions to your HSA until the tax return filing deadline the following year (without extensions) until the limit is reached to maximize your HSA contribution benefit.

On the flip side, if you make a withdrawal for noneligible medical expenses before the age of 65 years, you will have to pay tax on that amount and a 20% penalty. With tax and penalty combined, over 50% of the distribution could be forfeited. If you are 65 years or older, there is no penalty, but the withdrawal amount is still taxed.

Another benefit of owning an HSA is that you may keep your HSA open and continue to enjoy tax-free growth and tax-free withdrawals even if you are no longer eligible to make contributions. This means when you are no longer enrolled in an HDHP, change employers, or leave the workforce, your HSA can remain open.

With a better understanding of how HSAs operate and their benefits, it is easier to appreciate their value. As the owner of an HSA, you will not only gain the triple benefit of tax-deductible contributions, tax-free earnings, and tax-free withdrawals but also the opportunity to build a healthy medical nest egg to cover current and future health care expenses.