“These are the benefits of HSAs of which we must never lose sight… HSAs provide huge advantages to families of more moderate means, particularly as vehicles to build ‘rainy day’ medical savings and as a means to reduce the financial impact medical bills pose to family budgets.”
William G. (Bill) Stuart
Director of Strategy and Compliance
May 10, 2018
I get really excited when thinking about Health Savings Accounts.
That’s one reason why my kids’ teachers never invited me to career day. The parents who are firemen, nurses, palm readers, circus performers, balloon artists and musicians dominated those sessions. They all have cool uniforms, attention-grabbing props or compelling stories to share with elementary-school children.
Parents who are tax accountants, who apply waterproofing agents to basements in new residential construction and who spend their days reading the tax code? Not so much.
Last week, I participated in a panel discussion at an industry conference with four other industry experts who share my passion. The topic was the future of HSAs. The panel included representatives from two large national banks and one regional bank, as well as another regional administrator like Benefit Strategies.
We spent most of the 75 minutes talking about the increasing overlap that we all see between financial planning and medical coverage. A growing number of financial advisors now realize that HSAs can play an important role in their clients’ retirement planning. Here’s why:
Immediate tax savings. HSA contributions through an employer’s Cafeteria Plan aren’t subject to federal income or payroll taxes (or to state income taxes, except in Alabama, California and New Jersey). In contrast, contributions to Roth 401(k) and Roth IRA plans are subject to income and payroll taxes. Contributions to traditional 401Kk) and IRA plans aren’t subject to federal or state income taxes), but they are subject to FICA payroll taxes.
So, if you deduct $3,000 annually ($250 per month) from your pay to fund each of these accounts, your contribution to the Roth 401(k) plan would be $2,100 (assuming 30% combined federal and state income taxes and FICA taxes), to the traditional 401(k) plan would be $2,770.50 and to the HSA would be $3,000.
Long-term tax savings. After repeating this same contribution for 30 years at a 6% annual growth rate, balances would grow to $166,000 in the Roth 401(k) plan, $219,000 in the traditional 401(k) plan and $237,000 in the HSA. At that point, both the Roth 401(k) plan and the HSA allow tax-free distributions for qualified expenses. The HSA balance is $71,000 higher.
Contributions to the traditional 401(k) plan and HSA enjoy similar but not identical tax-treatment. Payroll taxes assessed on traditional 401(k) plan contributions reduce the balance by $18,000 versus the HSA.
Spending in retirement. Roth 401(k) plan distributions are tax-free, regardless of the items purchased. Someone with $10,000 in annual medical expenses in retirement has a sufficient balance to cover about 16½ years of expenses (assuming no account growth for simplicity).
The traditional 401(k) plan owner must withdraw $12,500 annually at a 20% marginal income tax rate to make taxable distributions to pay $10,000 in annual medical expenses. Her balance lasts about 17½ years.
The HSA owner, like his Roth 401(k) plan counterpart, pays no income taxes when he withdraws funds for qualified expenses (like Medicare premiums, Medicare cost-sharing, and dental and vision expenses not covered by Medicare). His balance lasts about 23¾ years.
Investing the Next Dollar
We spent time talking about an emerging hot topic among financial planners who understand the power of HSAs: Where should clients invest their next dollar of retirement savings?
The answer isn’t as simple as it used to be two decades ago. Then, a 401(k) plan represented the best option, since it enjoyed tax advantages not available in other accounts. Today, the answer is a little more complicated.
The panel agreed that savvy retirement savers need to look at both their 401(k) plan and HSA options when thinking about retirement savings. For many savers, the best option looks like this:
- Fund your traditional 401(k) plan up to the amount necessary to receive the full employer match. For example, if your employer matches 50% of your contributions up to your first $6,000 of contributions, you need to make sure that you contribute $6,000.
2. Contribute your next dollars to your HSA. The caveat is that you don’t spend this money, regardless of your medical need, but instead commit to saving it for retirement medical expenses.
3. Make additional contributions to your traditional 401(k).
The description above is the calculation process, not a chronological sequence. Let’s say you and your spouse want to save $15,000 toward retirement – an aggressive and laudable goal. And let’s say you have 24 pay periods per year. Given the facts above, you might contribute $6,000 ($250 per pay period) to your 401(k) plan, then $4,200 ($175 per pay period) to your HSA and $4,800 ($200 per pay period) to your 401(k) plan.
Thus, you would ask your employer to withhold $450 per pay period for 401(k) plan contributions and $175 per pay period for HSA contributions. If you plan to reimburse qualified expenses from your HSA as well, you need to adjust this payroll deduction figure upward to reflect both your planned savings and your distributions from the account.
The key element in the success of this plan is discipline (or good health). It’s easy to preserve balances in the 401(k), since any distributions are subject to taxes and penalties. It’s harder to save in an HSA when you’re making regular deposits and then you face an unexpected bill that you can pay with tax-free reimbursements from the HSA. You must exercise the discipline to stay the course.
Remember, you can increase your HSA contributions (up to the statutory maximum of $3,450 for self-only coverage and $6,900 for family coverage in 2018) at any point during the year, either through a Cafeteria plan or personal contributions. You can also reimburse current qualified expenses at any point in the future. You can pay an expense with personal funds (preserving your HSA balance designated for retirement savings), then reimburse yourself tax-free years later for that expense.
The Other Huge Benefit of HSAs
During the question-and-answer session, a member of the audience asked whether we’d agree that HSAs are primarily for higher-income people who can afford to save for retirement.
I’ve never been so glad that someone asked a question. I jumped on it. We had been so focused on the emerging awareness of HSAs as financial accounts that we’d neglected to emphasize a major benefit that many people, particularly critics of HSAs, too often overlook.
Most Americans are a few paychecks from bankruptcy. Survey after survey after survey after survey shows that we don’t have an emergency fund to tap when we face an unexpected bill for a service that we need to purchase, medical care, an auto repair or appliance replacement, for example.
HSAs can help consumers in two important ways.
First, by systematically directing regular payroll deductions to their HSAs, people can build some level of savings to pay for unexpected medical, dental and vision expenses. It helps that a deduction of $50 per pay period reduces net pay by about $35, yet the full $50 is available to spend tax-free on qualified expenses.
In this case, the discipline of regular deposits and the tax advantages that minimize the impact of savings on take-home pay combine to help Americans save for a health-related rainy day.
Second, individuals with established HSAs who incur expenses without sufficient balances to reimburse them can reimburse those expenses years later from future HSA contributions. Imagine you have a $200 HSA balance and face a $1,000 expenses. You need to find an additional $800 somewhere, such as a loan from a friend, credit card, or home-equity line of credit. You can then repay the friend or pay the credit card or HELOC by running your payment through your HSA as a contribution and distribution, thus saving state and federal income taxes and payroll taxes.
The Most Overlooked HSA Benefit
This benefit is often overlooked. I wrote about a year ago [https://www.benstrat.com/hsagps/2017/05/25/introducing-the-medical-discount-card/ ] , referring to an HSA as a discount card. It has the same effect as a store loyalty card, delivering a 20% to 35% discount (depending on your tax rate) on every qualified item that you purchase. So, even if you never build a large HSA balance over time, every dollar that you contribute to and distribute from an HSA delivers tax savings to you.
In the early days of the 115th Congress in March 2017, Sen. Martin Heinrich (D-NM) issued a US Congress Joint Economic Committee report entitled Health Savings Accounts are Not the Answer. The report argued that HSAs were not the answer because families with lower incomes aren’t able to contribute up to the statutory maximum into their HSAs. They simply don’t have adequate income to build their accounts as wealthier workers do.
This line of thinking is not limited to Sen. Heinrich and his colleagues. HSA critics often point to account balances at the end of the year to show that higher-income families can accumulate funds in their HSAs, while lower-income families exhaust their entire balances and don’t have funds to carry over into future years.
Of course that criticism could be extended to Health FSAs as well. By law, Health FSA elections are spent during the plan year, which results in no remaining balance at the end of the year (with limited exceptions with the introduction of Health FSA extenders such as the grace period and limited carryover).
Yet no one launches this criticism at Health FSAs. Why? Because that’s what Health FSA are designed to do, to provide families with tax relief when they reimburse qualified expenses. And that’s precisely what HSAs are designed to do, except with the added benefit that participants who don’t spend all their money can roll it over without limit.
I remember the timing of Heinrich’s report because the senator distributed it a month after the funeral of my sister-in-law, who lived in Heinrich’s home state. She passed away after a long battle with cancer (and probably against her insurer). I don’t know how her husband managed to pay their out-of-pocket expenses for two deductible years of treatment. I know only that if they had an HSA, at least they would have paid about 25% less than would someone with similar bills and no HSA.
These are the benefits of HSAs of which we must never lose sight. Yes, higher-income families can take advantage of the favorable savings treatment of HSAs, just as they can with qualified retirement accounts. But HSAs provide huge advantages to families of more moderate means, particularly as vehicles to build “rainy day” medical savings and as means to reduce the financial impact of medical bills pose to family budgets.
What We’re Reading
Will people continue to buy medical coverage through ACA marketplaces now that the penalty for not purchasing a policy will be zero beginning in 2019? The Kaiser Family Foundation has conducted polling among potential buyers to provide some preliminary answers.
The politics of health care are fascinating. A coalition of conservative groups has been meeting for months to design a new approach that preserves the ACA in states that support the law and allows other states to design new approaches to maximize coverage and control cost within guard rails set by the federal government. We’ll discuss this effort in more detail in an upcoming column. For now, you can read more here .