How Does a Health Savings Account Save Taxes?

A Health Savings Account (HSA) is a special type of bank account that can only be opened by an individual with a high-deductible health insurance plan.   HSAs have multiple tax benefits.  Here are the top five benefits of having an HSA:

First, the money deposited to an HSA is tax deductible as an above-the-line deduction.  Above-the-line is important because the deduction will reduce your adjusted gross income or AGI.  Your AGI is a number used to limit many other tax benefits; so reducing AGI is almost always a good thing.  A lower AGI may make more active participation rental losses allowable, more of your IRA contribution deductible, allow you to put more money into a Roth IRA, allow more education tax credits, allow more of Series EE bond interest to be excluded from income, and reduce the phase-out of personal exemptions & itemized deductions.

Second, the money you deposit to an HSA is still yours to spend.  You are the owner of the HSA account.  If you have an HSA, the money you have deposited and related earnings can be withdrawn for qualified medical expenses tax free.  Qualified medical expenses for an HSA generally are the same as those medical expenses that would be deductible as an itemized deduction.  However, medical expenses claimed as an itemized deduction must exceed a floor of 10% of your AGI before they provide any tax benefit.  (If you are age 65 or over the floor is only 7.5% through 2017).  The HSA allows you to spend your medical dollars on a pre-tax basis.

Third, you don’t have to spend the money you deposit to an HSA this year.  The money you deposit to your HSA can grow and the earnings are not taxed unless you spend the money on non-qualified expenses.

Fourth, eligible individuals can take a one-time distribution from an IRA to fund an HSA without including the IRA distribution in income.  This is known as a qualified HSA funding distribution.  I like to call it an HSA rollover.  The amount of the HSA rollover is allowable to the extent of the HSA contribution limit for the year.  HSA funding limits for 2013 are $3,250 for self-only plans and $6,450 for family plans.  Individual who are age 55 or older get an additional $1,000 added to the limit.

Fifth, an employer can make a contribution to an employee’s HSA.  When an employer makes a contribution to an employee’s HSA, the employee receives the contribution without having to include it in his/her income.  Not only is the HSA contribution free from income tax, it is also excluded from earnings for purposes of social security tax and Medicare tax.

There is a catch if you live in California.  California does not conform to federal laws regarding HSAs.  Consequently, there is no deduction allowed on your California income tax return for HSA contributions; any qualified medical expenses paid from an HSA will qualify as medical expenses on your California income tax return; earnings from an HSA account are taxable in California; there is no IRA to HSA rollover provision; and when an employer makes a contribution to an employee HSA account the amount is considered taxable wages.

If you are interested in learning more about HSAs contact one of the tax professionals and Seid & Company, CPAs.