Remember the first time you tried sushi? After my formative years of mom cooking chicken at 385° for somewhere in the neighborhood of 10 hours until it was deemed safe to eat, raw fish was a tall order. I nervously took the plunge with a spicy salmon roll that kicked off a now 15-year sushi habit. The point? Some things can be scary when you’re unfamiliar with them. In the personal finance world, Health Savings Accounts (HSAs) are the tobiko roll of insurance. Read on in this month’s blog post to learn about how an HSA might not only save you money each year in insurance costs but also how it can be a powerful retirement planning tool.
What is an HSA?
Think of an HSA like a 401(k) or IRA but for healthcare. You put money into an HSA pretax, just like an IRA, invest it, and let it grow tax free. Here’s the big difference between the tax treatment of an IRA and an HSA. With an IRA, you’ll eventually pay taxes on distributions from the account when you hit retirement. With an HSA, when you take a distribution for a qualified medical expense, you pay nothing in taxes. So, using an HSA reduces your tax liability when money goes in and then you never pay tax on that money again if used for a qualified medical expense! Pretty sweet if you ask me but what makes an HSA even sweeter is that after you turn 65, you can use the money within the HSA for anything you’d like and pay no penalty, only ordinary income tax, on the distribution.
Who can qualify for an HSA?
As long as you choose a qualifying High Deductible Health Plan (HDHP) from your insurance options through work or through the open market, you can make contributions to an HSA. Take a look at this chart to see what it takes to be considered a HDHP:
| For the 2019 Tax Year | ||
| Single | Family | |
| Minimum Deductible | $1,350 | $2,700 |
| Maximum Deductible | $6,750 | $13,500 |
| Maximum Out of Pocket | $6,750 | $13,500 |
There are no income eligibility requirements but you can’t be considered a dependent on someone else’s tax return and you can’t be enrolled in Medicare (because Medicare would not qualify as an HDHP).
Is an HSA right for me?
Now that you have an idea of what an HSA is, let’s look at how you can figure out if an HSA can work for you. First, you need a few different figures to estimate your upcoming healthcare costs and whether or not you’ll fair better with an HSA or a traditional PPO.
You’ll need:
- Your Income Tax Rate
- Monthly Insurance Premiums for the HSA and PPO
- Your contributions to your HSA
- Employer Contributions to your HSA
- Expected Healthcare expenses for the next year
No one can predict with complete accuracy how much they’ll incur in healthcare expenses in the next twelve months but thinking about things like if you are expecting a child or have a chronic condition can help you narrow down what you’re likely to spend.
Here’s an example of what the inputs for comparison could look like:
| Income Tax Rate | 25% |
| Monthly Insurance Premium HSA | $90 |
| Monthly Insurance Premium Traditional PPO | $350 |
| Your HSA Contributions | $2000 |
| Employer Contributions to your HSA | $1000 |
| Expected Out of Pocket Healthcare Expense HSA | $1000 |
| Expected Out of Pocket Healthcare Expense PPO | $0 |
Now it’s math time! Don’t worry, we won’t be doing anything too complex.
First, we’ll work out your expected costs for a Traditional PPO. We know your PPO monthly premium is $350 that is deducted pretax from your paycheck. $350 x 12 months is $4,200 a year. Because the premium is taken pretax from your paycheck and your tax rate is 25%, the after-tax cost to you is $4,200 x (1 – 0.25) = $3,150. Because we estimated you would have no out of pocket expenses with your PPO, your total after tax healthcare expense for the year is $3,150.
On to the expected costs for an HSA. Your monthly premium is $90 which is also taken out of your paycheck pretax. $90 x 12 months is $1,080 a year. $1,080 x (1 – 0.25) = $810 after tax. You also made $2,000 in HSA contributions which you’ll get a tax break on as well. The after-tax cost of our contribution is $2,000 x (1 – 0.25) = $1,500. With your HSA we estimated you’d have $1,000 in out of pocket medical expenses. Your company’s contribution to the HSA was $1,000 which we’ll treat as a negative number as it reduces your healthcare expenses.
Now to total these costs up:
| After Tax Insurance Premiums | $810 |
| After Tax HSA Contributions | $1,500 |
| Employer HSA Contributions | ($1,000) |
| Expected Out of Pocket Healthcare Expenses | $1,000 |
| Total After Tax Expenses | $2,310 |
In this example, you save $840 by using an HSA even with the additional $1,000 in out of pocket expenses that you did not incur with the PPO. This example should at least give you a base understanding of how to decide if an HSA is right for you but it’s always a good idea to consult with a professional.
How can an HSA bolster my retirement?
If an HSA can save you money each year in after-tax healthcare costs it may also give you an additional pot of funds to draw from during retirement.
In the previous example, you had $1,000 in expected out of pocket healthcare expenses. There’s no law that says that you have to cover those expenses from your HSA. For people with enough income and savings, those expenses can be covered right from your bank account, leaving the funds within your HSA the chance to grow tax free for years. For high earners that are already taking full advantage of the normal avenues of tax deferral like 401(k)s, 403(b)s, SEP and SIMPLE IRAs, etc, HSAs offer another opportunity for tax deferred growth. For example, if you decided at age 40 that you would benefit from the switch to an HSA and began maxing your annual HSA contribution for a family ($7,000 in 2019) and assuming regular increases in the max contribution allowed each year along with a $1,000 annual contribution from your employer and 6% in annualized growth, at age 65 you would have an HSA totaling just over $600,000! Like I said earlier, after 65 you can use these funds for any expense you would like with no penalty, only ordinary income tax on the distribution. But beware, any distribution made before age 65 for a non-qualified expense will be taxed as ordinary income and penalized an additional 20%.
Making the shift into an HSA from a traditional health insurance option takes some planning and a bit of foresight. For the people that can benefit from the change, HSAs are a compelling option to save on healthcare costs year after year while also gaining an additional chance to sock away some tax deferred savings. If you feel like you can benefit from the change or would like to learn more, we’re happy to help!
Check these sites out for more info on HSA’s:
https://www.healthcare.gov/glossary/health-savings-account-hsa/
https://www.nerdwallet.com/blog/health/what-is-an-hsa/
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