HSA: a friend on the road to financial freedom
Minimizing your tax burden further through healthy living and flexible accounting
Minimizing your tax burden further through healthy living and flexible accounting
For this week’s post, I decided to step back from our discussions on happiness and talk about something actually important — saving money.
A few weeks back I wrote the wildly popular article “Most money you can earn without paying a dime in tax”. We talked about all the different programs Uncle Sam offers to reduce our tax bill at the end of the year. There’s the traditional ones we hear about all the time like 401k’s and IRA. There’s a mention of a few less common ones as well. I encourage you to read it if you haven’t yet.
However, one of the most controversial options I mentioned was the Health Savings Account — also known as the HSA. Turns out, some people are not aware of all the super powers of the HSA and in turn ended up paying unnecessary taxes to the government. Thus; I’ve decided to break it down for you in a digestible way.
First, let’s talk about what HSA is used for. HSA is a savings account (I bet you didn’t see that coming) that allows you to save money for medical purposes. Each dollar that you set aside in an HSA is tax free. The money in the account can be invested in the stock market and grow tax free. Once you have a medical expense, the money can be withdrawn from the account, once again, tax free. You get the idea. One caveat is that HSA is only available for high deductible health plans.
Of course, the government cannot allow you to put every single penny you earn towards medical expenses. There is a limit of $3,450 per person or $6,900 for a couple per year. That’s 2018 numbers.
Here’s a quick example of how it would work. Assume your household income for 2018 is $100,000. If you were to max out your HSA for you and your spouse, the government would tax you on $93,100 instead of the entire $100,000. That’s a free, ~$1500 you don’t have to pay in taxes!
Aside from federal income tax, there’s a few other taxes snuck into your pay stub. Two of them are social security and medicare — affectionately known as FICA. Together they add up to 7.65% of your income. Turns out, unlike all other retirement accounts available to you, HSA is the only one that is exempt from paying FICA taxes too. That’s another ~$500 in your deep pockets.
That’s just the beginning though. Once you’ve set aside the money in your HSA, the most powerful force in the universe takes over — compound interest. That’s because each dollar you’ve set aside can be invested and grow tax free. Naturally, as a FI (financial independence) pursuer, you’d invest it in a diversified index fund of stocks*. Over time, the growth alone could dominate any further contributions.
Let’s also address the elephant in the room. What do you do if you don’t need to spend all this money on health care? What if you’re healthy? Once again, you’re in luck. Aside from being healthy, once you hit 65, all the money saved up in your HSA can be used for anything penalty free. You heard that right; anything. Taxation is also simple. It is treated like regular income. In essence, your HSA becomes a traditional IRA. One exception is if HSA is used for medical purposes. In that case, withdrawals are still tax free.
This beast of Roth and Traditional IRA blended and fused together sounds like a great deal, doesn’t it? Should you then go ahead and switch your health plan at work to a high deductible plan as soon as possible? Probably.
However, there is one notable exception. If you tend to have high medical bills throughout the year, it doesn’t make much sense to switch to a higher deductible health plan. You could be better off forgoing the tax savings and letting the employer subsidize your health costs instead.
Also, keep in mind that some generous employers contribute to your HSA as well. It does count against your overall limit but free money is free money.
Finally, there’s always going to be a subset of people who are terrified of exposing themselves to a little bit more risk through the high deductible health plan. I suggest that you read my article addressing insurance in general appropriately named “what to insure”. To summarize it in one sentence, I’d say, don’t worry about it if you can afford it.
*I need to write something an article, or more likely a series about stock investing for the FI pursuer.