The MOST Tax-Advantaged Investment Account is not a IRA or 401(k)
The MOST tax-advantaged investment account is not your retirement account like an IRA or 401(k), but instead a healthcare account. Health Savings Account, or HSA, is a savings account available for individuals on a type of health insurance called a high deductible healthcare plan (HDHP). In an HDHP you are responsible for 100% of your healthcare cost up to some amount, but limited in your maximum out-of-pocket cost. These amounts adjust each year for inflation. In 2021, in order to qualify as an HDHP, the plan will require you to pay at least the first $1,400 out of your pocket if you are an individual, or the first $2,800 for family coverage. These are your deductibles. Your insurance will pick up the rest of the tab once your out-of-pocket expense reaches $7,000 for individual coverage or $14,000 for family coverage.
In general, traditional health insurance plans have higher monthly premiums compared to HDHPs, but it will likely incur a smaller fee each time you visit the doctor’s office. They generally also have lower out-of-pocket maximums. It’s not too different from your car insurance. The lower the deductible (out-of-pocket expense to you in case of an accident), the higher the monthly premiums.
If you visit the hospital on a regular basis, it is likely that a traditional plan will be a more cost effective plan. The cost of health insurance plans vary from plan to plan, and how much your employer covers varies by employer. If you are healthy and don’t visit the hospital except in case of emergencies or for regular check-ups that are 100% free, then an HDHP is worth a serious consideration for the following reasons.
In order to cover the minimum and maximum out-of-pocket expense, individuals on an HDHP are given the opportunity to fund special healthcare spending accounts called HSAs.
What makes an HSA extra special is that the tax benefits exceed that of a traditional IRA/401(k), and Roth IRA/401(k)! HSAs are often called the only account with a TRIPLE tax benefit. The next three benefits are related to taxes:
Benefit #1: Contributions to HSAs are tax-deductible, meaning there is an immediate federal tax benefit just like contributions to a traditional IRA. If you are expected to be in a marginal tax rate of 24%, a $1,000 contribution will yield a federal tax refund of $240.
Benefit #2: There is no tax on capital gains, dividends, and interest inside an HSA - investment growth is tax-free.
Special note: Almost all states, with the exception of California and New Jersey, follow the federal tax benefits for HSAs for state tax. California and New Jersey hate their residents and provide no state tax refund for your contributions and tax capital gains inside HSAs.
Benefit #3: Withdrawals from HSAs are tax-free, as long as they are used for the wide range of qualified healthcare expenses. There are hundreds of qualified expenses, including the following. For a full list, visit WageWorks.
Benefit #4. If you are fortunate enough to not need a visit to the doctor’s office in any given year, the money inside an HSA automatically rolls over to the following year. The money inside an HSA is yours to keep and use for healthcare expenses whenever you need it. This is not to be confused with an FSA, or flexible spending accounts, where you will most likely lose any unused money if it is not used by a specified time.
Benefit #5: Savings in an HSA can be invested just like an IRA. Combine that with the fact that your HSA can be rolled year over year, and you can use your HSA as an investment account. You are not required to use your HSA for healthcare expenses.
Benefit #6: HDHPs will almost always have lower monthly premiums relative to traditional healthcare plans. As a healthy individual or family, you can use the savings from the lower monthly premiums to make contributions to your HSA.
Benefit #7: Assuming your employer is covering part of your health insurance premiums, HDHPs are lighter on their pockets as well. Many employers will pass on their savings to you by making a contribution to your health savings account. This is free money that may help cover part, if not all, of your occasional visits to the doctor’s office.
But wait. There’s more!
Bonus benefit: In addition to federal income tax and most state taxes, contributions to HSAs also avoid the payroll tax, which is a combination of Social Security tax (0% - 6.2%) and Medicare tax (1.45% - 2.35%).
Using the same example above, that means a $1,000 contribution to your HSA could result in a tax refund of $240 + $76.50, or $316.50! Contributions to traditional 401(k) and IRAs avoid income tax but not payroll tax, so another reason the HSA is the most tax beneficial account. In order to avoid payroll tax, contributions to your HSA must come directly from your paycheck through your employer (like your contributions to a 401k account).
Summary of the 7 + 1 benefits of HSA:
Tax benefit for contributions with no income limit
Tax-free investment growth
Tax-free withdrawals for qualified expenses
Unused dollars are automatically rolled over
Account can be invested in stocks, bonds, ETFs and mutual funds
Lower premium relative to traditional plans
Potentially free money from your employer
Bonus: No payroll tax (6.2% for Social Security + 1.45% for Medicare)
HSA’s are the most tax advantaged investment account, but your healthcare needs should be the driving force in choosing between a traditional health insurance plan (such as HMO or PPO) or the HDHP. If an HDHP is the right healthcare option for you, you should ABSOLUTELY be maxing out your HSA. It is an all-in-one account that takes the best features of traditional and Roth retirement accounts, and even takes it a step further by avoiding payroll taxes. If your healthcare needs change, remember that you can always change your health insurance election during open enrollment every year in November.
