Most employers require you to select your benefits package during an open enrollment period each fall, and this is a key opportunity to make some tax saving decisions. Most W-2 wage employees are aware of the importance of contributing to their 401(k) plan each year, but are they missing out on an even better tax savings opportunity? For many employees, contributing to a Health Savings Account (HSA) can provide a higher tax benefit as well as easier access to the funds (prior to retirement) for qualified medical costs.
Who can contribute to an HSA?
You can contribute to an HSA if you are not enrolled in Medicare, and your medical health plan qualifies as a High Deductible Health Plan (HDHP). For 2020, the IRS defines a high deductible health plan as any plan with a deductible of at least $1,400 for an individual, or $2,800 for a family. Additionally, an HDHP’s total yearly out-of-pocket expenses (including deductibles, copayments, and coinsurance) can’t be more than $6,900 for an individual, or $13,800 for a family (this limit doesn’t apply to out-of-network services.) If you’re not sure which plan offered by your employer will qualify as an HDHP, consult with your HR or benefits department during open enrollment.
How much can you contribute to an HSA?
The 2020 contribution limits are $3,550 if you are the only person covered by your insurance plan, or $7,100 if you have family coverage. Additionally, if you are age 55 or older, you can contribute an additional $1,000 per year. These annual limits apply to combined employer and employee contributions to the HSA account; so if your employer makes a contribution to the plan on your behalf, the amount you are able to contribute will be lower than what is shown above in order for the combined contributions to equal the maximum.
Triple tax benefit of HSA contributions
- Tax benefit #1: Your HSA contribution reduces the portion of your wages that are subject to federal income tax.
- Tax benefit #2: If your gross W-2 wages in 2020 do not exceed $137,700, your HSA contribution will also avoid 7.65% of FICA (Social Security) and Medicare tax on the contributed amount (if your gross wages exceed $137,700, you will only avoid the 1.45% Medicare tax on the HSA contribution amount.)
- Tax benefit #3: If you use your HSA funds to pay for qualified medical expenses, any earnings on the account will also be tax-free.
Tax benefit #2 is unique to HSA accounts, and this is the primary reason they provide a higher lifetime tax benefit than a 401(k) account. Additionally, there are only a few rare instances when you can withdraw money from your 401(k) prior to retirement without paying a penalty; but the HSA funds are available penalty and tax free at any age as long as they are used to offset qualified medical costs (see IRS publication 969 for details on what qualifies https://www.irs.gov/publications/p969.)
Contribution recommendation: match, HSA, non-match
Ideally, you will have sufficient income to allow you to contribute to both your 401(k) and an HSA plan each year. If this is the case, I recommend prioritizing your plan contributions as follows:
- Priority #1: Contribute enough to your 401(k) to maximize the amount of employer matching contributions for which you are eligible.
- Priority #2: Contribute the maximum amount to your HSA plan.
If you have covered these first two and can invest more of your wages for retirement, contribute as much as you are able to your 401(k) plan.
In summary, if an HSA plan is available through your employer and you qualify to contribute, don’t miss the opportunity to add HSA contributions to your overall tax and retirement planning strategy. Combining the tax benefit and easy access of an HSA with the long-term retirement funding of a 401(k) is a wise move.
K. Paul Hansen, CFP® CPA
