With the rising cost of healthcare in the United States, many are looking for ways to save on medical expenses. Employers are continuing to push healthcare costs onto workers, making monthly premiums higher than ever.
In addition, high-deductible health insurance plans have become increasingly popular. For these reasons, people turn to health savings accounts for savings on medical expenses. Let’s discuss what a health savings account is and explain its triple tax advantage.
What Is a Health Savings Account?
A health savings account, or HSA, is a medical savings account with tax benefits. HSAs can be used for eligible health expenses including medical, dental, and vision. HSAs can’t be used for health insurance premiums, however.
You’re only eligible to contribute to an HSA if you’re enrolled in a high-deductible health insurance plan. High-deductible plans are defined as health insurance plans with an annual deductible of $1, 300 or more for individuals and $2, 600 or more for families in 2017.
1. Contributions Are Tax Deductible
The first tax advantage of an HSA is that contributions are tax deductible. When you contribute to an HSA with after-tax money, you can deduct those contributions on your tax return for savings. You have until the tax deadline of the following year to contribute to an HSA for the current year. For example, you will have until April 18, 2017 to make contributions for the 2016 tax year.
Related: HSAs are One of the Four Savings Accounts that Everyone Should Have
The contribution limits for HSAs in 2016 are $3, 350 for an individual and $6, 750 for a family. For the 2017 tax year, the only change will be that the contribution limit for individual accounts will increase by $50.
In some cases, employers may allow employees to contribute to HSAs with pre-tax dollars through automatic payroll deductions. In this case, the contributions won’t be tax deductible. However, your taxable income will still be reduced throughout the year because of your HSA contributions. Employers can, at their discretion, make contributions to your HSA as an additional benefit.
2. Earnings Grow Tax-free
Did you know you can invest the money in your HSA? Yep, you can invest in mutuals, ETFs, etc.
Let’s say you have $10, 000 saved up in your HSA but have only spent $2, 000 of that balance. The remaining $8, 000 can be invested in the stock market so that it can grow while you’re not using it. Any gains the account experiences are tax-free. You won’t pay tax on the investment earnings.
Learn More: Using Your HSA as a Retirement Investment Vehicle
This is a major tax advantage because of the power of compound interest. Instead of paying taxes on your investment gains, the money will continue to grow. Those investment gains will build up over the years as you continue to contribute to your HSA and let the unused funds grow. If you contribute the max to your HSA each year and continue to have an unused balance, you can see how the account can grow a considerable amount over time. Since HSAs don’t expire, you can use these funds for medical expenses into retirement.
3. Distributions for Qualified Medical Expenses Are Untaxed
When you use your HSA for qualified medical expenses, your money won’t be taxed at that time. For example, if you need to pay for a $20 prescription, you can use your HSA debit card and make the purchase with your tax-free money. Or, you can pay from one of your regular accounts and then reimburse yourself from your HSA for the full $20. In this way, the distributions for qualified medical expenses are untaxed.
Your HSA provider should be able to provide you with a list of qualified medical expenses. Optum Bank, an HSA provider, provides a brief description of some qualified medical expenses as well as some expenses that don’t qualify.
Given the rising costs of medical expenses, especially in retirement, this advantage can result in sizeable tax savings.
Final Thoughts
As you can see, the triple tax advantage of HSAs really adds up. By not paying taxes on contributions, earnings, or withdrawals, you are effectively paying for medical expenses completely tax-free! For this reason, an HSA is a powerful tax saving tool.
HSA contributions reduce your taxable income each year you contribute. The best thing to do is to set up automatic contributions and contribute the maximum amount allowed by the IRS each year. Remember, since HSAs don’t expire, you can use any unused funds all the way into retirement for medical expenses.
Don’t forget that HSAs allow for tax-free investment growth. When you consider how much you’d pay otherwise in capital gains taxes, you’ll see that this is a huge tax benefit. You can choose from a wide range of mutual funds, bonds, etc. to invest your money.
The one drawback is that you’re only eligible for an HSA if you have a high-deductible health insurance plan. If you have determined that a high-deductible health insurance plan fits your needs, then an HSA is a wonderful tool to use.
