We’re just a month away from the tax filing deadline for 2017 – which is also the deadline for making last year’s tax deductible contribution to a Health Savings Account (HSA). A HSA is a personal savings account that allows you to pay for qualified medical expenses – including vision and dental, with tax-free dollars. This, in and of itself, makes utilizing an HSA extremely valuable. But it’s the less-known ancillary benefits of the HSA that make it the most efficient savings vehicle around. This is because an HSA offers a trifecta of tax benefits: tax-deductible contributions, tax-deferred growth, and potentially tax-free distributions.
TAX-DEDUCTIBLE CONTRIBUTIONS: To be eligible for a Health Savings Account, you must have a High Deductible Healthcare Plan (HDHP) and the IRS sets limits on how much you can contribute to an HSA per year. For 2017, that amount was $3,400 for a single plan and $6,750 for a family plan – if you are over age 55, you can contribute an additional $1000. Employers will usually let you make HSA contributions via payroll deduction, but you can also deposit money into your HSA directly from your personal bank account. Like an Individual Retirement Account (IRA), contributions to a HSA are tax-deductible, meaning every dollar you contribute to an HSA reduces your taxable income and lowers your overall tax liability. These dollars then remain in your personal saving account and you can use them to pay for qualified medical expenses at the time of your choosing.
TAX-DEFERRED GROWTH: Health Savings Accounts are housed at a bank or other financial institutions and will generally receive a nominal amount of interest earnings. This interest accrues tax-deferred and therefore is not a taxable event. The benefit here is not in the few dollars received from interest, but in the tax-deferred nature of the growth. You see HSAs can also be invested and just like an IRA, all growth on those invested assets are also tax-deferred. This allows a great opportunity to grow your HSA over time by investing the dollars and taking advantage of compound growth over time.
TAX-FREE DISTRIBUTIONS: If distributions from an HSA are made to pay for qualifying medical expenses, both tax-deductible contributions and tax-deferred growth can be taken out tax-free. To illustrate – let’s say Johnny B. Good has a family HDHP and over the past few years has contributed a total of $20,000 into his Health Savings Account. Starting this year, Johnny decides to invested his $20,000 into a well-diversified & low-cost portfolio for the next five years. If we assume a modest return of 6% over those five years, Johnny’s account would appreciate to roughly $26,750. All of which could be used to pay toward his family’s qualified medical expenses – all of it TAX-FREE.
THE LONG GAME: It’s safe to say that as we age medical expenses become a larger line item in a person’s budget. In preparation for this, the HSA offers an incredibly opportunity to efficiently cover these expenses both now and in the future. In fact, as savings accounts go, the HSA is the most tax advantaged account available. The tax-deductibility of contributions give it a leg up on even the Roth IRA! Because of this, try maxing out your HSA contributions each year and let the account accumulate over time. If you find yourself with a healthy balance in the account, consider investing a portion of your HSA dollars to take advantage of compound growth. Then, utilize tax-free distributions of both your contributions and growth in the account to pay for qualified medical expenses.
Words of Caution:
Investing your HSA exposes it to market risk and there’s no guarantee your account value would go up – it could also go down. Therefore, investing your HSA dollars should only be considered if you are willing to accept the investment risk and if you don’t foresee needing to use the HSA dollars in the near term. Also, make sure distributions are taken to cover qualified medical expenses. If distributions from an HSA are taken and NOT used for qualified medical expenses, you will pay ordinary income tax on the distribution amount and will be subject to an additional 20% penalty tax. If you are over age 65, HSA distributions that are not used for qualified medical expenses will avoid the 20% penalty, but they will still be included as taxable income.
David Kern is a Wealth Management Advisor at Wealthquest – a Cincinnati based financial planning and wealth management firm that offers a full range of financial services under one roof, for one simple fee.