Health Savings Accounts (HSAs) are relatively new to the health insurance field. An HSA is a tax friendly savings account that is available to anyone who signs up for a High Deductible Health Plan (HDHP), which must meet certain IRS requirements.
Income Tax Benefits
Unlike most retirement accounts, HSAs are double tax advantaged. Both your contributions and withdrawals to the HSA are tax exempt, as long as they are only used for health expenses. If your HSA is sponsored by your employer and your contributions come directly out of your paycheck, the contributions are exempt from all taxes, including FICA taxes. If your contributions are made with after tax income, you are able to deduct the contributions on your tax return to reclaim the federal and state taxes, but the contribution will have still been subject to medicare and social security taxes. So for both convenience and tax purposes, you are best off having contributions made directly from your paycheck.
What this means for you depends on your tax bracket and effective tax rate. In other words, the tax advantage varies from person to person. However, lets assume that your effective tax is 15% between federal and state taxes after all deductions. On top of that, your pay is subject to 7.65% FICA taxes (medicare and social security). If you contribute $1,000 to your HSA directly from your paycheck, you’re only sacrificing $773.50, in take home pay. Remember, that $1000 in your HSA is still yours, so you’ve basically just made $226.50 in free money. Actually, you’ve probably made a little more, since you’re reducing your income in your highest tax bracket.
Now, if don’t have your HSA contribution taken out of your paycheck, you’re still allowed to deposit money into the account with your take home pay. At the end of the year, you’re able to write these contributions off on your federal and state taxes. Assuming the same tax rates, a $1,000 contribution to your HSA is now sacrificing $850 in take home pay, since you’re not dodging the FICA taxes. Still a win, but not quite as big as having the contributions made directly from your paycheck. And being realistic, for most people, once their paycheck hits their bank accounts, it’ll never see an HSA.
Emphasis on Savings
If you’re familiar with Flex Spending Accounts, an HSA may sound familiar. But with a Flex Spending Account, your contributions had to be spent by the end of the year, or else you lost them. I always thought that was an awful deal. Appropriately, HSAs have ‘savings’ in their name because they are meant to help you save. An HSA, and the money in it is always yours. You need to be enrolled in an High Deductible Plan to start an HSA and to make contributions to the HSA, but if you leave the HDHP, the money that is already in the HSA stays with you in the HSA. You also get to keep the HSA when you leave your employer and when you retire. Better yet, your HSA can earn interest and investment gains, all of which are tax free as well, and all of which stay with you.
Remember though, the HSA is only meant to be used on health expenses. If you get caught using your HSA elsewhere, you owe taxes and penalties on the money. Technically, you could say this is a drawback of an HSA. I view it as another positive. I view my HSA as my second emergency fund and the rules on the HSA just keep me from being remotely tempted to spend that part of my emergency fund where I shouldn’t be. Of course you don’t want to use your HSA as your only emergency fund, since you won’t be able to use the money to fix your furnace or flat tire.
Employer Sponsored HSAs
If you are covered by an employer sponsored High Deductible Health Plan, your employer also likely offers an HSA through a particular bank. You don’t have to go with the bank that your employer works with. But, unless you have a real compelling reason not to go with your employer sponsored HSA, you should.
Firstly, in most cases, your employer will only offer to take HSA contributions directly out of your paycheck if you open an account with the HSA they offer. This gives you the extra tax savings of avoiding FICA taxes.
Secondly, employers usually pay some or all of the account maintenance fees on the HSA. Since HSAs are still relatively new, its still hard to find banks that offer fee free HSAs.
Thirdly, many employers offer a match on your contributions to the HSA. Its likely that you will only be eligible for the match if your contributions are made to the employer sponsored HSA and directly from your paycheck.
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- While I do strive to only write accurate information and dispense valuable advice, I am not a licensed financial adviser. All information is based solely on my personal experience and personal research and should be treated as such. Find out more.