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Health savings accounts: planning opportunities and pitfalls

By Alyssa Yocom and Janelle Woods

Health savings accounts (HSAs) have been a popular way to pay for healthcare expenses since their creation in December 2003. However, many advisors and clients with HSAs aren’t as familiar as they should be with the planning opportunities and pitfalls of these accounts, thus losing out on opportunities for wealth enhancement.

Individuals and families enrolled in a high-deductible health insurance plan are eligible to contribute to a health savings account. The 2022 HSA contribution limit for individual high-deductible health plans is $3,650, and the limit is $7,300 for family plans. A $1,000 catch-up contribution is allowed for individuals age 55 or older, and up to $2,000 can be contributed if both spouses are covered by the high-deductible plan and are both age 55 or older. It is important to note that once enrolled in Medicare, an individual is no longer eligible to contribute to an HSA.

Tax advantages

When planning for retirement, it’s easy to overlook HSAs because their contribution limits are lower and they are less widely available than defined contribution plans. However, HSAs offer three (and a half) unique tax advantages:

  1. Distributions from HSAs are tax-free when used for qualified medical expenses.
  2. Interest and investment earnings within the HSA grow tax-free.
  3. Contributions to an HSA are tax-deductible.
    • Contributions made through payroll deductions are not subject to FICA and FUTA taxes.

Many individuals use the funds in their HSA to cover current medical expenses. However, delaying distributions from the HSA results in a longer tax-free compounding period which can extend an HSA’s benefit well into retirement. HSAs can also be a valuable tool for early retirees. For those retiring before age 59½, having funds to access for living expenses free of taxes and penalties is a high priority.

How it works

During a client’s high-earning years, they may enroll themself and their family members in a high-deductible health plan. The client can contribute up to the annual maximum to their HSA and pay for medical expenses out of pocket instead of using funds from the HSA. For expenses paid out of pocket, the client would maintain receipts for documentation of future withdrawals from the HSA as reimbursement.

If the client then decides to retire or make a career change at age 55, for example, they would be able to reimburse themself for prior medical expenses to help with cash flow before age 59½. These reimbursements would not be subject to income tax, as they are for prior medical expenses paid out of pocket. HSAs used in conjunction with a strategy of tax buckets that include taxable accounts and Roth accounts can be a valuable way to create an income stream for early retirees.

Flexible income planning

A bonus long-term consideration for the use of HSAs is that a high-income client contributing to their employer’s retirement plan could have significant required minimum distributions (RMDs) later. RMDs are not required from HSAs.

Qualified medical expenses

Distributions from HSAs are only tax-free when used for qualified medical expenses. Qualified expenses include most medical and dental procedures, vision care, prescription drugs, lab fees, long-term care insurance premiums, and Medicare premiums. Furthermore, an HSA can be used to cover qualified medical expenses for an individual, their spouse, or any tax dependent—even if they are covered by a different health plan.

HSAs cannot be used to pay for supplemental Medigap insurance premiums or over-the-counter drugs. If a distribution is taken from a health savings account and is used for nonqualified medical expenses, the distribution will be subject to income tax, and if the distribution is taken prior to age 65, a 20% excise tax may also apply.

Common pitfalls for advisors and how to avoid them

Not asking clients about HSAs. Health savings accounts are relatively new, and some clients may have an HSA but not know what to do with it. Consider asking all clients whether they have an HSA—you may find that more clients have these accounts than you thought.

Not reviewing HSA beneficiaries. Advisors should review the beneficiary designations on clients’ HSAs. When a spouse inherits an HSA, the account retains its pretax status. However, if a nonspouse beneficiary inherits the HSA, the account would be distributed and the income is taxable to the beneficiary in the year of the original owner’s death. As a result, a child in a high federal and/or state income tax bracket is not an ideal beneficiary for these accounts.

Not funding or investing HSAs. Advisors should work directly with clients who have HSAs to ensure that they are contributing to the account and ensure that the account is invested. Some HSA providers require a portion of the account to remain in cash, but the remainder should be invested according to the client’s investment policy statement.

Distributing funds from the HSA when cash flow is sufficient to cover medical expenses. Advisors should educate their clients on the benefits of saving and investing funds in an HSA. Depending on the client’s unique situation, it may or may not make sense to use the HSA to cover medical expenses in the current year. If cash flow permits it, clients may benefit from delaying reimbursements from the HSA until early retirement. In this way, the account can remain invested so it grows tax-free for longer. Clients should save receipts and records for medical expenses as they occur, even if they plan to delay reimbursement.

Alyssa Yocom, CPWA®, CFP®, is a wealth manager at Schultz Financial Group Inc. in Reno, NV. Janelle Woods, CFP®, MBA, is a regional managing director at Cookson Peirce in Akron, OH. Both Yocom and Woods are members of the NAPFA Women’s Initiative.

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