There’s a savings account with a potential advantage over your 401(k) plan — and it just might help you save on taxes. It’s your health savings account, and it’s offered alongside your high-deductible health-care plan.
Not sure if you want a high-deductible, HSA compliant health-care plan? Read on before deciding to choose "the least expensive" monthly payment plan. You may be surprised.
HSAs come with three main tax benefits: You can contribute to them on a pretax or tax-deductible basis, and your savings grow free of taxes over time. You can also make tax-free withdrawals to cover qualified medical expenses.
There’s a fourth less well-known tax advantage: Contributions you make to your HSA on a pre-tax basis avoid Social Security and Medicare taxes, often known as FICA taxes (Federal Insurance Contributions Act). The same applies to contributions your employer makes to your HSA. This FICA tax is 15.3% that you share with your employer.
The point is so compelling, it can spur companies to make even larger employer contributions to workers’ HSA accounts. In 2018, workers in high-deductible plans with HSAs received an average annual employer contribution of $603 for single coverage and $1,073 for family coverage, according to the Kaiser Family Foundation.
For 2021, the annual limit on deductible contributions is $3,600 for individuals with self-only coverage under an HDHP (a $50 increase from 2020) and $7,200 for family coverage (a $100 increase from 2020).
The limits on annual deductibles are also subject to annual inflation adjustments. For 2021, the lower limit on the annual deductible for an HDHP is $1,400 for self-only coverage and $2,800 for family coverage, both unchanged from 2020. The upper limit for out-of-pocket expenses is $7,000 for self-only coverage and $14,000 for family coverage, both increased from 2020.
Extra tax savings
For example, take a married employee who is in the 24% federal income tax bracket is setting aside $7,000 annually on a pretax basis into his HSA.
This person would save more than $535 annually in Social Security and Medicare taxes alone each year. Further, those contributions aren’t subject to federal income taxes, resulting in another $1,680 in annual savings. This participant would save even more if he or she resides in a state that doesn’t subject HSA contributions to income tax.
Optimize contributions The contributions you make to a traditional 401(k) plan aren’t subject to the same tax treatment as your HSA savings.
While 401(k) plan contributions avoid federal income taxes, they still face the FICA tax. When you withdraw money from this retirement account, the distribution is subject to income taxes, plus a 10% penalty if you’re under 59½. Meanwhile, distributions from an HSA are tax-free if they’re for qualified medical expenses. But if you pull the money out for other reasons, you’ll pay income taxes and a 20% penalty that’s in effect until you’re 65. After age 65, you can deduct funds from your HSA for non-Medical items, adding to the allure of these accounts.
Contribute at least enough to get the match on your 401(k). This is free money. The most common match formula employers use is 50 cents on each dollar on the first 6% of pay.
Save at least enough in your HSA to meet your annual deductible. Cash left unused in your HSA rolls over into the future. Got extra dollars to save? Max out your HSA and invest it for the long term. Your CPA or insurance adviser can help you plan for each tax year. then, stash any remaining dollars into your retirement plan.