Health Care Savings Accounts:  If you can, you absolutely should

By Bob Peters || May 24, 2023

The only triple tax advantage investment vehicle

A Health Care Savings Accounts (HSA) is an absolute must do if you have a qualifying medical insurance plan and can set aside dollars each year.  The HSA is the only triple tax advantage investment vehicle available (more on that later) and by funding this early in your life you can set yourself up for a much better future with less stress as you age and need more health care later in life.

Let me introduce you to your partner…the government

I remember one of the first years I prepared my own tax return.  I had worked as a waiter in a restaurant and was going to school.  When I received my W-2 the following January and prepared my tax return I was horrified to find that I owed roughly $1,000 in taxes.  I think that year I earned a little over $11,000 and did not have nearly enough in my checking account to pay my tax liability.  I called my dad, a bit sheepish with a hint of incredulity, and asked him for a loan.

I recall my dad telling me that I had learned two important lessons:  1) I needed to better estimate how much should be taken out of my paycheck so that I would not have a big unexpected federal tax liability (payroll withholding) and 2) from that day forward I now needed to embrace my lifelong silent partner who was going to earn a percentage of my income for the rest of my life (aka the government).

Form W-4

When you start to work for an employer one of the first documents you will need to submit on your first day will be a Form W-4.  This form is short and very easy to complete.  It is basically your instructions to your employer about how much you would like withheld from your paycheck to be credited towards your federal taxes.

Your primary objective is to withhold enough to cover what your tax liability will be.  If you withhold more than needed you will be giving your silent partner (federal government) an interest free loan which will be repaid to you the follow year in the form of a tax refund.  While tax refunds are better than needing to write a check because you owe additional taxes, ideally you would have estimated your withholdings such that the government only receives what they are owed.  You may not get a tax refund this way, but you had the use of the funds earlier in the year, so that in and of itself, is better.

How your silent partner gets paid

Your silent partner is the federal government (and additionally those States that have imposed an income tax).  Because not all States do levy an income tax, we will put state income taxes aside for now.

Your silent partner gets paid in what is a progressive tax system.  Progressive is a term that is often used in a political context but that is not the relevant definition for the purpose of federal taxes.  A progressive tax system assigns a rate of tax liability that increases as your income increases.  Here are the 2023 Federal Income Tax Rates that apply to single, married filing jointly, or head of household.

 Source:  Internal Revenue Service

Susie and Tax Rates

Let’s pick a fictious 25-year-old person named Susie.  Susie is single and is employed by a major health care company and is expected to earn $90,000 in 2023.  At this step in the process, we can do an initial tax calculation but don’t worry we will get to lower the tax liability in a minute.

Based on the table above, before any deductions or tax credits, Susie would owe $15,307 in federal taxes.  We calculated this by adding the following three numbers $1,100 which represents 10% tax on the first $11,000; $3,804 which represents 12% tax on the next $31,724 of earnings and $10,400 which represents 22% tax on the last $47,275 of earnings.

Susie’s effective tax rate, before deductions, is 17.0% ($15,307 total taxes paid divided by $90,000 total earnings).  Her marginal tax rate is the rate of tax on the last dollar earned …in this case it would be 22% because $90,000 falls inside of the 22% tax rate band.  It might now be easier to see why we call our tax system “progressive” …the more you earn the higher the rate of tax on your earnings.

Before we get into the good stuff

Deductions and Tax Credits

Ok, now let’s take a look at deductions and tax credits and how these can lower your final tax liability. 

The government allows you to calculate your taxes by either 1) itemizing or 2) taking the standard deduction.  You pick either 1) or 2) by determining which method would give you the greatest deduction.  Some current expenses that would be allowed to be itemized would include the interest expense associate with a primary residence, property taxes that are paid on real property, deductions you might make to a qualifying charity like the Salvation Army or a Church.  There are many more.

Since not everyone owns a home or could benefit from all of the expenses that are allowed to be itemized the government gives us the option of choosing the standard deduction.  For a single taxpayer and a married couple filing jointly, the amount of the standard deduction in 2023 is $13,850 and $27,700, respectively.

In addition to the standard deduction there are a number of tax credits that are offered such as the child tax credit, earned income tax credit and education credits.  These credits phase out as your income increases which gives lower income taxpayers some degree of subsidy on their final tax liability.

Now back to the HSA and why you should fund this if you can

For simplicity purposes we have ignored any valuable tax credits that Susie might be eligible to deduct and chosen to see how the Standard Deduction and funding the HSA would help her. As mentioned at the beginning of this post, an HSA is available if you select a qualified high deductible medical insurance plan from either your employer or thru your state’s affordable care act insurance options.  Many, but not all, employers/states offer a qualified high deductible plan but, if they do, you need to take a hard look to see if this could be a good fit for you.

In the recent blog post, Insurance:  Why it’s important and some considerations we discussed the need to understand the cost of the monthly premiums, the deductible (how much you are self-insuring before the insurance policy kicks in) and any co-pays.  You absolutely need insurance as the cost of care, particularly emergency care, can quickly skyrocket into thousands (and tens of thousands) of dollars.  

An HSA is like a Roth IRA but even better

Let’s assume now that Susie has determined that her employer offers a high deductible plan that suits her budget and, therefore, she is eligible for an HSA account. Think of an HSA like a Roth IRA but even better.  Better in the sense that any amount she contributes to an HSA is a federal tax deduction in addition to the Standard Deduction that she elected, and, like a Roth IRA, all of the earnings will grow tax free if used for eligible medical expenses.  Also, like Traditional and Roth IRA’s, each year the amounts allowed to fund into an HSA are indexed to inflation.

For 2023, the maximum amount allowed to fund into an HSA for a single and married filing joint taxpayer is $3,850 and $7,750, respectively.  In 2024, those same amounts will be $4,150 and $8,300, respectively.

So now let’s recalculate Susie’s taxes.

By taking the Standard Deduction and partially funding her HSA Susie was able to reduce her federal tax liability by 29% and lower her effective tax rate from 17% to 12%.  The tax benefit attributable to just the HSA contribution is $671 (her marginal tax rate of 22% multiplied by the $3,050 contribution).

The Super-Power of an HSA and compounding

So far, so good.  We have seen that by fully funding one year of an HSA, Susie was able to have her silent partner, (the federal government) pay her $671 in the form of reduced current year tax expense.  But now let’s see the super-power of an HSA if Susie pays for her out-of-pocket costs for co-pays and deductibles with funds outside of her HSA and lets the $3,050 compound for 40 years.

Since Susie is young and in good health, she would typically have limited health care needs so the amount she might pay in out-of-pocket expenses are usually small.  Having said that, we are going to assume that Susie has an emergency reserve account established and is able to deal with higher, unexpected costs should they occur.

Looking into the future

Since we are looking out 40 years into the future, let’s first look back in history to see historical returns for S&P 500.  In the link to the May 18,2023 Motley Fool article we see that the annualized real return of the S&P 500 over 10, 30 and 50 year periods was 12.4%, 7.3% and 5.4%, respectively.  When looking far into the future it’s very important to look at “real” which is adjusted for inflation vs. “nominal” which is not.  By adjusting for inflation, we get a better view of the future purchasing power of compounding which is a more accurate way to compare these numbers…even though looking at nominal will really blow your mind.

Nobody knows what future returns will be, but the past does give us some reasonable assumptions.  For the sake of this thought experiment, let’s assume that the $3,050 was invested in a low cost, diversified index fund like VTI which owned a share of every public company in the US and that the investment grew at a “real” annualized 7.3%.  By using the Compound Interest calculator we see that in 40 years that $3,050 would grow to $51,084.  You can search for average healthcare costs of a 65-year-old, but many estimates today suggest that a 65-year-old couple would likely spend over $300,000 for the remainder of their life on health care. Susie does not know if she is average or if she will be married but $51,084 is a big step in the direction of covering her future health care costs.

Susie now sees that this is a pretty good deal and decides to keep investing $3,000/yr ($250/month) in her HSA for the next 10 years and letting these amounts compound by paying her out-of-pocket expenses with other than her HSA funds.  If we assume that each of these $250 monthly contributions also grows at a real 7.3% rate of return after 40 years, she will now have accumulated approximately $440,000!

Record Keeping and establishing a system to track expenses

Another great thing about an HSA is that all withdrawals from an HSA (like a Roth) are not subject to any federal tax if you apply these toward qualifying medical costs.  If Susie were to pay her out of pocket costs each year and keep a copy of the invoice from the provider and a record of her payment such as a scanned copy of a bank statement, she could accumulate these expenses and withdraw funds many years in the future tax free.  You will need to retain these records to support your tax free withdrawls should the IRS ever ask you for supporting documents.  

Let’s show a hypothetical example.  You may cringe with some of the future assumptions of out-of-pocket costs, but these costs increase as you age and as your family grows.  They are just guesstimates and we are going to assume that all of these out-of-pocket expenses are paid for from other than HSA funds until the age of 65 at which time she will begin to spend these for all out-of-pocket costs until her death.

At 65 Susie looks at the $440,000 HSA balance and is looking at a future where she and her partner might need to spend $300,000 plus.  Susie is elated since the $440,000 HSA balance is well in excess of the estimated future cost of her health care expenses.  Since she kept electronic copies of bills and payments on the $151,500, she incurred over the prior 40 years she decides to withdraw that amount and take her family on vacation, buy a new car, do a bathroom remodel and buy some new furniture.  The entire $151,500 can be taken tax free!

Further, she has $288,500 remaining to pay for her future medical and dental costs which will also continue to grow. She could even use those funds to pay for long term health care insurance. HSA amounts used for long term health care premiums are currently qualified expenses to be paid tax free.

Any amounts withdrawn for non-qualified expenses, after the age of 65, are only subject to Susie’s regular federal income tax rate just like a traditional IRA.

In Summary

-If you have access to a qualified High Deductible Medical plan (thru your employer or you’re your state’s ACA providers) you can then open an HSA.

-HSA accounts stay with you for your life and are transferable if you move employers.

-HSA’s provide you with the only triple play tax benefit…you get a tax break when you make the contribution, your investments grow tax free and your withdrawals are not subject to tax if they are used to pay for eligible expenses.

-If you have sufficient income to make the annual contribution and pay for any out of pocket medical/dental expenses you will accumulate a large HSA over many years with only a few years of contributions.

-Even if you need to rely on some of your HSA account balance to pay for current medical/dental healthcare your retained balance will grow and help you out in the future.

-Here is a link to the IRS website covering HSA’s.

-There are often Flexible Spending Arrangements (FSA) also offered by many employers.  While you get a tax benefit from using these accounts any unused balance at the end of the year is forfeited which means lost dollars and no compounding.

-Sometimes parents and grandparents are looking for gift ideas and they may be interested in helping you build up an HSA.

-The Government is your life long silent partner and there is no better tax benefit than an HSA.

-Disclaimer:  This post is to illustrate taxes and benefits of the HSA rules as best that I understand them.  Whenever you make financial decisions that involve tax advice and planning you should seek out professional advice.  I’m not a CPA and the rules often change so good to do your own homework. This post is not meant to be specific tax advice for your situation.