Health Savings Accounts (HSAs) are often overlooked or misunderstood, but they provide a noteworthy tax savings strategy for high-income earners when utilized correctly. Specifically, they provide access to a triple tax-advantaged account with the potential to beat the utility of even your 401(k) plan. You can contribute to your HSA on a pre-tax or tax-deductible basis, your savings grow tax-free, and you can also make tax-free withdrawals from the account to pay for qualifying medical expenses. What’s more, if you optimize your contributions and refrain from making withdrawals, your HSA can also serve as a valuable – and flexible – retirement asset.
Below, we’ll discuss the details of why high-income earners should consider utilizing an HSA.
The Basics: How HSAs Work
A Health Savings Account is designed to pay for certain qualifying health care costs, and it is federally tax-exempt. Eligible individuals are those who are not enrolled in Medicare, and who have high-deductible health care plans (HDHP), the definition of which changes year to year according to the IRS. If you have an HSA, you can contribute to it annually and receive an immediate tax deduction, which is certainly useful if you are a high-income earner. However, this reduction of your taxable income is only one of several tax-savings benefits. Most often, an HSA will start as a cash account that earns interest, but it can become an investment account once it reaches a threshold balance. Any investment gains earned by your HSA are tax-free, and any funds you withdraw to pay for qualified medical expenses are also tax-exempt.
Many employers provide HSAs, but that’s not the only way to open one. As long as you meet the eligibility requirements, you can open an HSA on your own, too.
Is an HSA the Same as an FSA?
While many people confuse HSAs with Flexible Spending Accounts (FSAs), it’s important to know that they are distinct. FSAs require that you spend down your funds each year – otherwise, you forfeit your contributions. Conversely, you can keep funds in your HSA over the long-term and, since the money can be invested, you’re actually incentivized to keep funds in your account unspent.
For 2021, contribution limits are $3,600 for individuals and $7,200 for family coverage. If you’re 55 or older, you can also make a catch-up contribution of $1,000 annually.
Optimizing the Triple Tax Advantage as a High-Income Earner
Health savings accounts are the only option for triple-tax savings, as mentioned above, yet many people utilize just the tax-deductible contributions and the ability to withdraw tax-free to pay health care expenses. If you really want the power of the HSA to work for you, however, look to the HSA’s third tax advantage and use it to bolster your retirement plan, too. If your income allows you to contribute the maximums each year and pay for health expenses out of pocket, rather than using HSA funds, you can let your account grow tax-free until you retire. Put simply, if you want the most bang for your HSA buck, you’ll want to make full use of all three tax advantages so you can enjoy the ultimate in tax efficiency.
What’s the Catch?
Given the above, an HSA can almost seem too good to be true. However, in an environment where tax-advantaged opportunities for high earners seem to be shrinking, HSA accounts provide a valuable benefit. Contributing gets you an immediate tax deduction and lowers your taxable income, and you can build a fund to pay for a variety of out-of-pocket medical expenses, like co-pays, deductibles, and prescription drug costs. If you’re able to avoid using your HSA funds for those types of expenses during your working years, you can use your HSA as a long-term investment account that will grow tax-free and pay for your health care needs in retirement. If you end up not needing it for that purpose once you retire, you can simply withdraw your money after age 65 for any purpose and pay regular income tax on it.
Using Your HSA as a Retirement Asset
If you’re able to avoid withdrawing HSA funds for medical expenses before you retire, you gain greater flexibility once you leave the workforce. Here are four ways you can use your HSA if you commit to building it as a retirement asset:
Bridging to Medicare
You’ll become eligible for Medicare at age 65 and, if you retire before that time, you may need help bridging the gap until your eligibility begins. Although you cannot typically use HSAs to pay private health insurance premiums, there are two exceptions: paying for an employer-sponsored health care plan under COBRA, and paying premiums while you are receiving unemployment compensation. Both could be helpful if you lose your job, or you decide to stop working before age 65.
Paying Medicare Premiums
Once you become eligible for Medicare, you can no longer contribute to an HSA – but you can utilize funds you’ve already contributed. You are permitted to use your HSA to pay for your Medicare premiums for both Part B and Part D. However, you may not use it to pay supplemental policy premiums.
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Helping to Cover Long-Term Care
HSAs can also be used to cover a portion of the cost of a long-term care insurance policy. You are permitted to do this at any age, but the amount you’re able to use increases as you grow older. With health care costs for retirees continuing to rise, and about half of the retirees requiring long-term care at some point, this is a tremendous potential benefit.
Paying for Other Expenses
Once you reach age 65, you will be able to use HSA funds to pay for expenses other than qualified medical expenses without incurring penalties. However, you will have to pay state and federal income taxes on those distributions.
Final Thoughts on Health Savings Accounts for High-Income Earners
If you’re earning a high income, chances are you’re already maxing out your 401(k) and IRA contributions and setting yourself up for a comfortable retirement, too. If you’re also saving in taxable accounts, you’re even further ahead of the game. However, if you haven’t yet begun utilizing an HSA, you may be missing out on an incredibly tax-efficient savings vehicle that offers tax advantages in the short term while also serving as an excellent way to fortify your retirement savings.
At Wade Financial Advisory, we help you manage every aspect of your financial life. We partner, educate, and guide you throughout the process to help you make well-informed financial decisions. If you have questions about HSAs or other tax-advantaged accounts, please reach out to us today.