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In the investment and taxation world, the benefits of an HSA – Health Savings Account is like hitting the jackpot but even better. Click to tweet this. You will have to pay taxes on the jackpot winnings, but thanks to hsa tax benefits you won’t have to pay taxes on money in an HSA when used on qualified medical expenses.
As long as you know and abide by the HSA rules you won’t ever pay taxes on money in an HSA account. There isn’t a better option to invest your money in while avoiding taxes.
Unlike an FSA you don’t have to use the HSA funds within a certain time frame to avoid losing them. In fact, an HSA is a financial account that you own and can function as a savings and retirement account.
An HSA is a Personal Savings Account
The most common way an HSA account is setup is through an employer. As part of a high deductible medical plan many employers will offer to contribute money to an HSA account on our behalf.
I don’t know about you but I’m not one to give up free money. So, most people sign up for an HSA account even if they aren’t adding to the fund themselves. The account is setup in your name and is available for you to use for medical purposes when you need it.
The Triple Tax Benefits of an HSA
HSA tax benefits are huge when used correctly. You will not be taxed:
- On Federal and most State taxes
- You will not pay federal taxes on money invested in an HSA so long as you don’t pass the yearly contribution maximums.
- You will also not pay state taxes on the money invested in an HSA unless you are in New Jersey, California, New Hampshire or Tennessee. In NH and TN you will only pay taxes on dividends and interest earnings over a certain amount.
- On interest you earn on the invested balance.
- When you use the funds for qualified medical expenses.
What does this mean exactly? Let’s say you are a single 35 year old person who makes $70,000 per year. That means the federal government will tax you 22% on all your earnings with a few exceptions and a Health Savings Account is one of them.
If you maxed out the $3,500 contribution limit, then you’d save yourself $770 in taxes that year. This does not include applicable state taxes, that changes depending where you live.
If you do this for the next 30 years until retirement, you will save $23,100 in federal taxes alone. Clearly, HSA tax benefits are quite powerful.
The Benefits of an HSA Beat All Other Saving Vehicles
Think of a Health Savings Account as a traditional IRA on steroids. The money put in an HSA can be invested just like a 401K.
Programs may vary slightly but generally once your HSA account balance has $1,000 in it you can start investing the surplus. The company managing your HSA account will have a list of investment options to select from.
If you’re nervous about managing the funds your HSA is invested in, take the investment challenge for beginners. You will learn how to understand the true profitability of a fund.
By the end of the challenge, you will be able to tell where your current investment funds rank against other fund options available in your portfolio. The growth of a fund is just as important as the fees associated with it.
An additional resource for those who are intimidated by the idea of managing their own investments is, “The Simple Path to Wealth,” written by JL Collins. JL Collins shows how a simple investment plan can have greater returns than a well thought out plan from a costly financial adviser could
Assuming you start maxing out the single contribution limit on an HSA of $3,550 at age 35, you could have $350,000 in your HSA account when you retire at age 65. This calculation used a conservative return on investment of 7%. The ending $350,000 is more than triple what you invested.
The true beauty of a Health Savings Account is the HSA tax benefits. With an HSA you won’t be taxed on any of these earnings as long as you use them for qualified medical expenses. A Roth IRA provides this incentive, but unlike an HSA, the money you initially put into the Roth IRA account is taxed.
The Healthcare Benefits of an HSA in Retirement
While many expenses drop in retirement, healthcare expenses spike. You could use your retirement savings from a 401K/Roth IRA/Traditional IRA account to pay for healthcare expenses, but at some point you pay taxes on those funds.
If you use your HSA account to pay for healthcare expenses in retirement you will never pay taxes on that money.
Tax Implications for Medical Expenses on a Traditional IRA
Let’s say you take out $50,000 a year from a traditional IRA once you hit 65. Any money used towards medical expenses from those funds will be taxed.
Assuming you’ll want basic healthcare coverage, be prepared to pay at least $140 per month or $1,680 a year for Medicare Part B. This part covers routine doctor visits. Rates for this part will only increase over the years so be prepared to pay more if it’ll be awhile before you hit 65.
With today’s tax brackets you can expect to be taxed 22% or $370 on the $1,680 you spend for Medicare Part B. Over 20 years, that’s $7,400 you will pay in taxes when you fund it using traditional IRA dollars.
Pay for Medical Expenses in Retirement with HSA Funds
Now, if you use funds from an HSA to pay for Medicare Part B you won’t pay any taxes. You save on taxes when you put the money into an HSA and when you take it out for medical expenses.
With the increased costs of healthcare in retirement it may be more beneficial to invest money into an HSA than a 401k. You definitely want to hang onto free money so make sure to maximize on any 401k match your employer offers first before putting money into an HSA. As long as you don’t touch the money in your HSA until retirement, it would make more sense to max out an HSA before a 401K.
HSA Funds Turn Into a Traditional IRA at Age 65
At the age of 65, the funds in an HSA essentially turn into a traditional IRA. This means you could withdrawal money for any purpose and not be penalized for it. You will have to pay taxes on what you take out not related to medical expenses though.
Consider Paying for Medical Expenses Out of Pocket Before Retirement
Prior to retirement, you may choose to pay medical expenses out of your pocket and leave your HSA funds untouched. There’s 2 reasons to do this.
- The money in your HSA will grow quicker and larger if you don’t have to touch it.
- You can pay yourself back later with funds from your HSA account when you need the money. You must SAVE YOUR RECEIPTS in order to withdraw the funds tax free at a later time, preferably in retirement.
Unfortunately, not everyone can enjoy the benefits of an HSA. Let’s review who qualifies for an HSA and what the rules are.
Who Is Eligible for the Benefits of an HSA?
Health Saving Account rules say you are eligible if you:
- are on a high deductible health plan
- have no other insurance
- are not enrolled in Medicare
- can’t be claimed as a dependent on someone else’s tax return
- are not covered by TRICARE or VA benefits
The Contribution Limits on an HSA
- $3,550 for singles
- $7,100 for families
Additional HSA rules on contribution limits:
- Employer contribution counts towards IRS max
- Post Tax contributions can be made and are above the line
- Contributions can be made up to the date tax returns are due
Qualified Medical Expenses An HSA Can Be Used For
- Out of pocket expenses
- Co pays, co insurance
- Prescription drugs
- Dental and vision care
HSA plans can be used for you, yourself and tax dependent (kids who are over 18 and not on your taxes are not covered, kids under 18 are covered even if they aren’t on your taxes).
Please note: There is a 20% penalty if funds are withdrawn early for non-medical expenses. You will also be responsible to pay taxes on the amount withdrawn early. It’s best to avoid this if at all possible.
Is an HSA Right for You?
An HSA is beneficial for anyone with a high deductible health plan. At the very minimum, the funds in an HSA go in tax free and can be used to pay medical expenses tax free. The less your hard-earned money is taxed the better!
When used for retirement savings, an HSA is a very powerful tool. In fact, an HSA is superior to a Roth or Traditional IRA when planning for retirement. To maximize your retirement savings potential, consider doing the following:
- Take full advantage of any 401K match your company offers. If your company will match 50% of your investment up to 4% of what you invest, then make sure you invest 4% of your earnings into your 401K plan.
- Next, max out your HSA contribution limit.
- Then if possible, pay for medical expenses out of pocket and SAVE THOSE RECEIPTS.
- Finally, max out your 401K contribution limit.
Remember you can adjust your 401K contributions at any time to account for medical expenses you need to pay for. Always make sure you are putting the minimum amount into a 401k to get the company match though. Don’t lose out on that free money!
There’s a lot of factors to consider when saving for retirement. A good next step is to take the investment challenge. It will show you what the best investment options are in your current investment portfolios. When done right, the investment challenge for beginners can greatly accelerate your savings rate.
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