The HSA Tax Trifecta
August 15, 2022
Welcome to The Retirement Tax Podcast, where hosts Steven Jarvis, CPA, and Benjamin Brandt, CFP, work together to bridge the gap between tax professionals, financial advisors, and their mutual clients to help reduce most people’s largest expense in retirement: taxes. Each week, they will dive into conversations around taxes, focusing on what you can truly control (instead of what you cannot) and how to set yourself up financially for your future.
Spending money on your health tends to be less than pleasant, but if we can get some tax savings from it, maybe we can save some money and find the silver lining. Many people ask about HSAs, so in this episode, Ben and Steven address the tax advantages of having an HSA and how to make the best use of one.
Listen in to hear about the difference in how you should approach an HSA vs. how you approach other accounts. You’ll get tips on how to make sure you are qualified, how much you can contribute, how itemization works, and more.
What You’ll Learn In Today’s Episode:
Read The Transcript Below:
Steven Jarvis: Hello everyone, and welcome back to The Retirement Tax Podcast. I am one of your hosts, Steven Jarvis, CPA. And with me as always, is my good friend, Benjamin Brandt. Ben, welcome back.
Benjamin Brandt: Oh man, so happy to be here. We’re going to talk about some fun tax tips today and answer a listener question, and I couldn’t be more excited.
Steven Jarvis: Yeah. I love that you could say fun tax tips with a straight face, not everyone can. I completely support that. I have a lot of fun doing these. So, let’s dive in and talk about health savings accounts.
Benjamin Brandt: Yeah. Spending money for your health is often not pleasant, but if we can get some tax benefits from it, maybe we can round the corner and find that silver lining and save some money as a fact.
Steven Jarvis: Yeah, and I definitely get questions from tax payers on a regular basis about health savings accounts or HSAs, because it’s a great tool. It’s actually one of the most tax-advantaged accounts that are out there. I can’t even get the words out right. There’s so much excitement in there.
Because HSAs not only let us put in dollars that we haven’t been taxed on yet, we also can withdraw those dollars tax-free if it’s for qualified medical expenses and those dollars can grow tax-free.
So, we’ve got kind of all three of these things going for us, that if we use the dollars correctly, we’re putting it in without paying taxes, we’re growing without having to pay taxes and we’re taking it out without paying taxes. So, that’s kind of the tax trifecta there.
Benjamin Brandt: Yeah, that’s great. So, with a little bit of preplanning, money that we were going to spend anyway, if we run it through this specific system or process, we can see some pretty significant tax savings over time.
Steven Jarvis: Yeah. So, there’s lots of great things about these accounts. The first thing we got to do is see whether or not we’re eligible to participate in one.
Unfortunately, you can’t just go sign up for an HSA just because you want to, it is tied to the type of healthcare coverage that you have. But it’s becoming more and more common that these options are available, whether through an employer or if you’re getting health insurance out in the marketplace, these types of plans are becoming more prolific.
So, for a lot of us, that option might at least be there. It can be a little bit of a change of mindset, if you are used to a more traditional health insurance coverage where you pay a high premium and then a lot of your medical expenses are then just covered.
There’s going to be a change in how we approach it because you have to have what’s called a high deductible plan. And there’s not a set dollar amount for what that deductible’s going to be in every case, because there’s a couple of things that get looked at.
So, I always really encourage people to make sure that you’re talking to your HR department if this is through an employer. Or if you’re getting out in the marketplace, make sure that the plan says that this is HSA eligible. There’s a couple of things in there and we don’t want to mess that up.
Benjamin Brandt: Right. And I think as we’ve seen health insurance premiums get more and more expensive over the years, we’re seeing the rise of the HSA because like with any kind of insurance, we’re talking about the transfer of risk.
If we want to transfer all of the risk to the insurance company, we pay for that in premium. If we’re willing to bear some of that risk upon ourselves, that’s less premium. So, again, insurance is always about the transfer of risk.
So, with the HSA, it’s a tax advantage way to accept some of that risk on yourself. And thus, you’ll get a lower premium likely as a result.
So, I think there’s combination of many things, people are looking to save on taxes, but then also, just as premiums have gone up, people are looking to say, “Where can I bear some of that risk with my emergency fund or with my has, and then keep those premiums a little bit more manageable.”
Steven Jarvis: Yeah. So, once we determine that we’re eligible to contribute to an HSA by having the right type of coverage, then we’ve got to look at how much can we contribute?
And there’s a little bit of nuance here that’s different than other types of tax advantaged accounts because for like IRAs or Roth IRAs, we look at how much can we contribute per person?
And for an HSA, we’re looking at how much we can contribute based on the type of coverage we have. And we’re looking at whether it’s individual coverage or family coverage.
And family coverage, it can mean a spouse, it can mean a child. It doesn’t necessarily have to be that it’s a couple that’s married, filing jointly and both are on the same plan.
So, we’re eligible, we have a high deductible plan, and then we look at our coverage. If we only have individual coverage for 2022, we can contribute up to $3,650 to an HSA. And for family coverage, we can contribute $7,300.
And then once we hit 55, there’s a thousand dollars a year catch-up that we’ll talk about a little bit more in just a second.
What I want to emphasize on these contribution limits, is that that is the limit, whether the employer is contributing or whether you are contributing or some combination thereof. It’s not $3,650 for the employer and the individual, that’s a combined total.
And so, that can get a little bit murky sometimes for people. As I’m doing tax returns. I see this get missed sometimes that a tax payer isn’t really aware how much their employer’s contributing.
So, either too much gets put in or they don’t realize that their employer hasn’t contributed the max and they’re not taking a full advantage of the account that there’s that additional amount that you can get put in there.
Benjamin Brandt: Right. And if you’re both contributing, you can deduct what you’re contributing. So, that is something that can be missed sometimes is that the employer contributes X amount and you contribute a thousand. But if you are not putting that on your income taxes in a way that you should, that’s an easy deduction to miss too.
Steven Jarvis: Yeah, especially for anybody listening, if you’re getting your insurance out in the marketplace and not from an employer, we really need to make sure we’re looking at this at tax time.
Because when we are doing HSA contributions through an employer, it’s going to come right out of our paycheck and it’s going to get reported on our W-2, on our pay stubs; here’s how much of our income was taxable, and it’s already going to take out that HSA contribution.
But if you have that health insurance directly and you’re not funding it through an employer, we’ve got to make sure it’s getting reported on the tax return or you’re going to miss out on the tax savings there.
Because there’s a separate form that needs to be included on, we’ve got to make sure that we’re actually taking advantage of this opportunity and not just letting that pass us by.
Benjamin Brandt: And that’s whether we itemize or not. Is that right, Steven?
Steven Jarvis: That’s correct. This is completely separate from whether we take the standard deduction or they’re itemizing. That’s a great point.
Benjamin Brandt: So, it’s for everybody.
Steven Jarvis: Yeah. This is for anybody with an HSA, it doesn’t matter if you itemize. An important note on that is that if you’re using HSA dollars to pay for medical expenses, those medical expenses can’t count towards potentially itemizing. But there’s a minimum amount of medical expenses you have to have to itemize anyways. And so, a lot of people don’t have that opportunity.
So, I’ve not personally seen a situation where using an HSA has been the difference on whether or not somebody can itemize.
There’s a few other things that we want to make sure we’re keeping in mind as we’re looking at HSAs. As I talked about that tax trifecta, one of those things in there was tax-free growth.
But this is one that gets missed a lot. When you put money into an HSA, almost across the board, by default, it’s going to go into some kind of cash account. And with a lot of administrators, you actually have to have a certain balance before you can invest it.
But most, probably all (I haven’t checked every single one of them) do have that opportunity to invest if you proactively go and do that. But you’re going to have to go in and make that choice.
And so, this highlights a couple of things. One, we got to make sure that we’re proactively investing it so that we’re taking advantage of that tax-free growth. And we also want to consider whether our goal is to use our HSA now, or to use our HSA to set ourselves up for later in life, for retirement, for when we might have even more medical expenses and potentially less monthly income.
So, a lot of people will look at an HSA as, “Oh, this is how I pay my monthly medical expenses.” Totally understand that, we don’t want people going out and taking out loans to pay for medical expenses just so they can hold onto that growth.
But for taxpayers who can afford out of their monthly cash flow to pay for their medical expenses, not out of their HSA account, this is a huge opportunity for these funds to grow tax-free and then be used tax-free.
And the medical costs on a kind of a average per person basis keep going up and up and up. The last number I saw was definitely hundreds of thousands of dollars. And so, I just don’t get too worried about my HSA growing too large.
I have family coverage. I use HSA personally, putting my $7,300 in there a year, and really looking forward to having that as part of, kind of my retirement war chest as I get later in life.
Benjamin Brandt: Yeah, same. Yeah, we have ours, family coverage through the business and then we can contribute to an HSA. You just have to decide based on your cash flow and what your liquidity is, is this a savings account for immediate needs?
Because if it’s immediate needs, you don’t have the time to really take risks with it. You’ve got to take risks to earn in return. So, it’s just in a money market or something, and you’ll get your 7 cents a year or whatever it’s going to be in return.
But you can also make a decision, “I’m going to treat this more like a Roth IRA. I’m not going to tap into it for a decade or a couple decades, and I’m going to grow this. I’m going to buy some growth stock index mutual funds, whatever it is. And I’m going to make this an investment account for the long term.”
If you make the decision — Murphy’s Law says you’re going to need to dip into it for a hip surgery during a downtime in the market. So, you really have to make the decision is this for short-term needs, that’s cash. Is this an investment account, long-term? I could take some risk.
But you don’t want to mix the two. You don’t want to be able to dip into this because it’s going to be like it is now where the market’s not doing so great. So, you want to separate those out.
Steven Jarvis: Yeah, and talking about managing risk; if you happen to be one of those fortunate people that you go through your whole life, you’re healthy as a horse, you never get to that point where you need a large amount of funds to pay for medical expenses — the HSA is still a great investment to have, because worst-case, you get later in life and decide, “Hey, I don’t need this for medical expenses.”
After you turn 65, you can actually take money out of an HSA, use it for whatever you want. It doesn’t have to be for qualified medical expenses. You will have to pay income tax at that point. So, essentially, at that point, it becomes more like a traditional IRA, but you’re not paying any penalties because you didn’t use it for medical expenses.
So, even if we think worst-case scenario, I go nearly my whole life and never have to have big medical bills (oh, how tragic would that be), we’re still going to have access to this money in a way that you’re going to be able to use it, very effective.
Benjamin Brandt: That’s true. And isn’t there a rule or the lack of a rule that says I don’t have to have my medical cost on the same year that I offset a distribution from my HSA. So, in theory, if you have good record keeping, you could have a knee replacement that costs $20,000 in 2022.
And then you sit on that. You wait until you’re 65, whatever it is, and you want to take that amount of money out of your HSA. You can actually use that old medical bill to offset that and not pay income taxes on it.
So, we don’t have to necessarily have the distribution being the same year. We can actually kind of sit on that.
Steven Jarvis: Yep. That’s a great point, Ben. So, as we go back to letting your HSA funds grow while you’re paying for medical expenses out of pocket now, there’s actually no time limit. We have to have the record keeping, but you could wait 20, 30, 40, 50 years and say, “Okay, now, I’m going to go back to 2022 and take a disbursement or distribution for that knee surgery.”
And you don’t have to maintain your HSA eligible insurance to take distributions later in life. Having the HSA eligible insurance is crucial for making the contributions, but if you change employers or when you get onto Medicare, which is not has-eligible, you still have full access to those funds for distributions. So, yeah, all great things to keep in mind.
Benjamin Brandt: Excellent.
Steven Jarvis: So, Ben, let’s real quick talk about a couple of potential planning strategies as we get a little bit closer to retirement around HSAs, and then we’ll switch and answer a listener question.
We’re going to talk about these just a little bit high-level, but things to think about and maybe things to follow up on if they might apply to you. You do have one opportunity in your lifetime to do a rollover from an IRA to an HSA.
It does count against your contribution limit that year. So, unlike doing from an IRA to a Roth IRA where we can pick how much we’re going to convert, IRA to HSA, we have to look at what’s our what’s our contribution limit.
But an opportunity to potentially get some funds out of our tax-deferred account and into a tax free account. So, potential opportunity there.
Benjamin Brandt: And that does count as your contribution for the year then if you do that?
Steven Jarvis: It does count as your contribution for the year. So, you want to make sure that if you’re going to do that, you don’t also make your max contribution through your employer or directly into the HSA. Because you’ll end up with excess contributions.
Benjamin Brandt: Should we tell the audience why you know the answer to that question?
Steven Jarvis: Well, there’s plenty of reasons, which one is top of mind for you?
Benjamin Brandt: Well, because when I was a student and there was a financial advisor facing — it was stump Steven question. And that was my question and you didn’t know the answer.
Steven Jarvis: Of course that’s what you’re going to bring up. No, that’s a fair point. The great thing about the tax code, it is basically endless and I don’t have the whole thing committed to memory. So, that was a-
Benjamin Brandt: That’s good, because I certainly don’t either, but I’m glad we know where to look for the answers.
Steven Jarvis: Playing tax code trivia is not a winning game for most people.
Benjamin Brandt: Right. You do it better than most though.
Steven Jarvis: Yeah. Well, thank you. So, we have that once in a lifetime opportunity to do a direct rollover from an IRA to an HSA. But if we have a couple of years between when we retired and when we get to Medicare age, when we get to social security age, and we have some lower income years, another interesting thing about HSAs is that you don’t have to have earned income to contribute, which is different than a traditional IRA or a Roth IRA.
So, if we’ve retired, we’re living off of our investments, which is not going to be earned income. At that point, we couldn’t contribute to a traditional IRA, but we could contribute to an HSA. And where this gets even more interesting is that taking a distribution from an IRA is a taxable event, but then making a contribution to an HSA is a tax deduction.
So, if we had some of those years where we were living off of our investment income at a rate of about $7,300 a year, if we had family coverage, we could be taking essentially money out of our IRA tax-free because we would take it out and it would go on our tax return as taxable.
Then we would contribute to an HSA and it would come back off our return and the net effect on our taxable income would be zero. And so, that’s a potential planning opportunity if we end up in kind of that sweet spot.
Benjamin Brandt: That’s fantastic.
Steven Jarvis: Alright. So Ben, let’s go with this listener question. We get a lot of questions related to Roth IRAs and Roth conversions, which is very understandable. It’s a very powerful tool.
And unfortunately, Google can tell you all sorts of things about the definition of a Roth. It’s really hard to find an answer on Google that says, “Should Benjamin Brandt convert $20,000 from traditional to Roth IRA?” So, we love that these questions come in.
And so, this question, which was from John says, “Does it make sense to convert $30,000 this year, pay the 22% federal tax and 5% state tax on the conversion with separate funds, but then lose the growth opportunity of the taxes now paid over the next 20 years?”
Benjamin Brandt: Yeah. So, this is a great question because this addresses the idea of if I do a Roth conversion, aren’t I starting in the hole? And all things being held equal, if I take money out of my retirement account, which is if I’m paying income taxes from a net worth perspective, I guess that’s what I’m doing, but specifically, in this case, paying from the conversion. I’m starting in the hole by whatever my effective tax rate was.
So, in this case, he’s using 22%. It’s probably less than that because of the effective tax rate. But I don’t know, I’m assuming that. But let’s just say $8,100, he’s starting $8,100 in the hole, because that’s what he paid in taxes.
So, is it still a good idea to do Roth conversions if, in theory, we’re starting in the hole and have to kind of grow our way out of the hole, and then that next dollar after our tax bill is where we start to sort of be in the money profit-wise from this decision that we made of a conversion.
So, it’s a common thing that comes up a lot. How I like to think of it … and I did a show about this on my other show; Retirement Starts Today, and yet the concept was, are you a Roth conversion purist?
And so, what a purist would do is they would say, “Okay, I’m going to do a $30,000 conversion, I’m going to pay $10,000 in taxes. I have two choices; when I go from the traditional to the Roth, I can withhold those taxes if I’m over 59 and a half, of course. And then I’m sort of starting in the hole, 30,000 left in my account, only 20,000 went to my Roth.”
A purist would say, “I’m going to take 30,000 from my traditional and put 30,000 in my Roth. I’m going to find that 10,000 in taxes from an underperforming asset, from cash, from savings, whatever that would be.”
So, the purist would say, “I want the exact amount to go from my traditional to my Roth.” And I’d say, “That’s great, if you want to be a purist, that’s fine.” But if you’re over 59 and a half, the important thing is that we get this conversion done because of the good things it can do for us and the bad things we can potentially avoid by doing the conversion.
So, even if it’s 70, 80, 90% efficient to do it with withholding, you should still do it. 80% efficient is better than not doing it at all.
So, I would say if you’re a Roth conversion purist, that’s fine, but don’t let that prevent you from doing the Roth conversion, if you do, in fact, think it’s appropriate for your personal financial situation, or if your advisor is giving you qualified tax advice and helping you kind of look down the road and around the corner to see if this is a good choice or not.
So, I would say it still does make sense to do it, even if we are starting in the hole because of the things that it gives us and the things that it can help us avoid. So, the things that it gives us is liquidity, tax liquidity.
If we don’t have a Roth IRA at all, and we’ve perfectly planned out our year, where we take the exact amount we need each month to avoid anything that we’re trying to avoid; extra health insurance, premiums, deductibility, social security, anything that it could be. And then Murphy’s law says on December 30th, the water heater blows up and I need to take 10,000 extra out of my IRA because my basement is flooded.
If we only have an IRA, we don’t have that tax flexibility. And all of the planning that we did around taxes was shot because we had that extra withdrawal at the end of the year. If we have a Roth, we avoid that because we have that tax flexibility.
Also, looking at down the road, our required minimum distributions will be less because we’ve taken out in sort of steps to fund the Roth. So, IRA is smaller. We’ve funneled more of that growth towards the Roth because hopefully, if our investment timeline is longer, we’re investing more aggressively in the Roth. So, our IRA balance is lower, less RMDs.
We have more income flexibility around, post-65 health insurance premiums, that’s income-based. So, if your requirement and distribution is super high, it could push you through those brackets.
Doing the Roth conversion systematically helps to avoid some of that or at least makes them less painful because there’s different brackets. If we’re in bracket three, but now, we’ve moved into bracket two because of those conversions, that’s a big money saver and headache saver.
So, just apart from the idea of potentially, we’re starting in the hole, there’s a lot of things that the Roth conversion does for us down the road. And in fact, if we never do spend the money and our beneficiaries end up with the money from the Roth, great, they don’t pay to income taxes either.
So, depending on your timeline, depending on how you’re looking at it, I’d say it it’s always a good idea even if we’re funding it through withholding from the conversion or if we’re a purist and we’re funding it through our savings.
So, that’s kind of my long-winded version of yeah, I think it still does make sense to do, but what are your thoughts, Steven?
Steven Jarvis: Ben, I absolutely agree. When we look at traditional versus Roth from kind of the math standpoint, yeah, it’s a timing decision of, do we pay taxes now or do we pay taxes later? And if tax rates stay the same or go up, we’re way better off being in Roth.
Benjamin Brandt: Or if your investment account balance goes up too. And investment, your account’s 500,000 today, it’s a million 20 years from now. You’re going to pay taxes on it eventually.
We’re not investing unless we’re optimists that the best companies in the world will continue to grow and human innovation never pauses our steps backward, it only moves forward. That’s what we’re investing in. At least that’s what I’m investing in, I hope that’s what everyone else is investing in. So, it always makes sense to pay it sooner.
Now, there are some exceptions where I think my income taxes are going to be much lower in the future, but for most people that are listening to this show (retirees), it does make sense to pay that bill when it’s lower.
Steven Jarvis: Yeah, absolutely. And aside from the pure math side of it, of what our tax rates going to be; you hit it right on the head. There’s all this other flexibility that comes along with it.
So, I’m a huge advocate for getting as much money in Roth as makes sense in our specific situation.
But it’s something I look at with every taxpayer I work with, even if ultimately, it’s not the right decision for a specific person, usually, due to a really unique situation that it’s not going to be the right situation — it’s something I’m going to look at every time. I’m never just going to assume that that doesn’t make sense, always going to look at that.
Benjamin Brandt: Excellent.
Steven Jarvis: Well, Ben, as always, love your insight, appreciate your in-depth answer to that question and getting on today and chatting with me about HSAs and Roths. It’s been fun as always.
Benjamin Brandt: Absolutely. I look forward to our recording sessions every time.
Steven Jarvis: And for everyone listening, of course, until next time, remember, don’t let the taxman hit you, where the good Lord split you.