The Quadruple Tax Benefit of Health Savings Accounts for High-Income Earners

Introduction:

As a financial planner working with high-income clients, I often discuss the benefits of Health Savings Accounts (HSAs). While HSAs are typically described as triple tax-free, for high-income households they can offer a quadruple tax advantage. Here's how it works:

1) HSA Contributions "Go In" Tax-Free

Similar to traditional IRAs or 401(k)s, HSA contributions lower your taxable income. In 2024, individuals can contribute $4,150, while families can contribute $8,350. Those over 55 can add an extra $1,000 (or $1,000 each if married). For example, a married couple filing jointly and earning $250,000 could reduce their taxable income by $8,350 with a maximum family HSA contribution. If their marginal tax bracket was 24%, that’s a $2,004 tax savings. The higher your tax bracket, the more you save.

Tax savings is a game of inches and good decisions compound!

2) HSA Contributions Grow Tax-Free

HSA contributions grow tax-free, and most HSA providers offer the ability to invest these contributions. This tax-free growth is similar to a Roth IRA, but with a significant advantage: HSA contributions do not get taxed on the front-end, unlike Roth contributions. This gives HSAs an edge over the already powerful Roth IRA. It’s one of the reasons why I recommend maxing out a HSA contribution as one of the first steps when overhauling a family’s ongoing saving/investment plan.

While investing your HSA isn't mandatory, it can be particularly advantageous for high-income households who have a control on their budget and spending. Many HSA providers offer a variety of investment options, allowing for potential long-term growth. Many high-income earners have the financial flexibility to cover current medical expenses from other sources, potentially allowing them to invest their entire HSA balance for future use. For those able to maximize contributions annually, this strategy can lead to substantial tax-free growth over time.

3) HSA Contributions "Come Out" Tax-Free

HSA funds can be withdrawn tax-free when used for qualifying medical expenses. There are no annual limits for how much of your HSA you are allowed to use for these types of expenses, just the amount you have saved in your HSA. While there are penalties for non-medical withdrawals (ordinary income tax plus a 20% penalty), the abundance of qualifying medical expenses options makes it unlikely to over-fund an HSA.

Even if you're healthy, here are a few ways to utilize HSA funds:

• Medicare premiums (A, B, C or D but not Medigap Plans)

• Certain Long-Term Care Insurance Premiums

• Dental and Vision Care

• OTC Medications

It's important to note the inheritance rules for HSAs. A spouse can inherit HSA funds tax-free, but non-spouse beneficiaries will owe ordinary income tax on the inherited amount. However, given the wide range of eligible medical expenses, this is typically not a major concern for most.

4) HSA Can Avoid FICA Tax Too

While Health Savings Accounts (HSAs) are widely known for their triple tax advantage, there's a fourth tax benefit for a specific subset of high-income earners: FICA tax savings. This often-overlooked advantage is particularly relevant for households where one spouse is a high earner and the other has access to an employer-sponsored HSA through a lower-paying job.

Here's the key: HSA contributions made through an employer payroll deduction (Section 125 plan or Cafeteria Plan) can avoid the 7.65% FICA tax (6.2% Social Security and 1.45% Medicare). For eligible high-income earners, there may also be potential to sidestep the additional 0.9% Medicare surtax.

It's important to note that for high-income earners above the Social Security wage base ($168,600 in 2024), they don't receive the 6.2% Social Security tax benefit on contributions above this threshold. However, they still benefit from the full 1.45% Medicare payroll tax savings on their entire taxable Medicare earnings. For those earning below the wage base, their FICA savings will include both the 6.2% Social Security and 1.45% Medicare taxes. It's worth emphasizing that this benefit primarily applies to contributions made through payroll deductions. Contributions made directly by an individual don't receive this benefit. Not all HSAs are created equal!

From a financial planning perspective, things get particularly interesting when considering married couples with different salaries and occupations. This scenario can create unique opportunities to maximize FICA tax savings through strategic HSA contributions. Let's explore an example to illustrate this:

A married couple where one high-income earning spouse earns significantly from their own business, while the other (lower-earning spouse) works for an employer offering an HSA-eligible health plan. [This situation is not uncommon; many business owners opt for health insurance through their spouse's employer.] By maximizing their family HSA contribution through the lower-earning spouse's employer plan, they can capture the full FICA tax savings on their contribution. For this specific scenario, the strategy could provide a substantial tax saving on every dollar contributed to their HSA (combining FICA and income tax savings). When combined with tax-free growth and tax-free withdrawals for qualified medical expenses, the HSA becomes an even more powerful tool for both current tax reduction and long-term financial planning.

It's important to note that while this approach may slightly reduce the lower-earning spouse's Social Security benefits, the impact is often minimal compared to the potential tax savings and long-term advantages. In many cases, the lower-earning spouse may be eligible for a higher spousal benefit based on their higher-earning partner's work record, rather than their own. However, each situation is unique, and it's crucial to consult with a qualified financial advisor or tax professional to understand the full implications for your specific circumstances.

For high-income families with the flexibility to cover current medical expenses out-of-pocket, maximizing HSA contributions through the lower-earning spouse's plan can be an excellent strategy to build a tax-advantaged fund for future healthcare costs. As with any financial strategy, it's essential to consider your overall financial picture, employer benefit offerings, and long-term goals before implementation.

Conclusion:

For high-income households eligible for an HSA, maximizing contributions should be a priority in your annual financial planning. While health insurance discussions may not be exciting, they're crucial, especially for high-income clients who may lose track of monthly premiums and deductibles.

A Few More Thoughts:

• If you have a high income and budget flexibility, consider a high-deductible health plan eligible for an HSA. However, it's important to note that this strategy may not be suitable for everyone, particularly those with ongoing health issues or difficulty saving for potential high deductibles. The high deductible you have to pay may cause the math not to work out in your favor.

• There are typically two approaches to HSA contributions. Some use funds as medical expenses arise, while others pay out-of-pocket for current expenses, allowing their HSA to grow through investments. This second approach involves saving receipts for potential future reimbursement. The practicality of this method depends on individual circumstances and lifestyle choice. Medical expenses in retirement can be substantial, which may provide opportunities to utilize HSA funds without receipt archiving tactics. However, it's important to note that tax laws and regulations can change, and the optimal strategy may vary based on your specific financial situation. Consider consulting with a qualified financial advisor or tax professional to determine the best approach for your long-term financial goals.

• The information provided about 2024 contribution limits and tax rates is subject to change. Readers should verify current limits with the IRS.