W. Scott Simon
Last month I said this column would show advisors how to enter the health savings account marketplace to gather assets and then invest and manage those assets. I am postponing that topic because there are still a number of HSA advantages I’d like to discuss further.
To briefly review, an HSA is an individually owned, tax-advantaged savings and investing account used to pay for qualified medical care expenses. An HSA isn’t a spending vehicle like a flexible spending account which, in most cases, requires an employee to spend down all the money in it by the end of each year; this “use it or lose it” requirement means contributions generally cannot roll over year after year, unlike HSA assets.
Rather, an HSA is a savings and investing vehicle, and savvy investment advisors are increasingly focused on the investing aspect of it.
HSAs are most often offered by employers in conjunction with a high deductible healthcare plan. It’s possible, however, to also establish an HSA without help from an employer. For example, individuals with medical care coverage under a Silver or Bronze Affordable Care Act policy can set up an HSA on their own. Just find an HSA firm that sells to individuals, which is typically an online process.
As mentioned last month (and in every article about HSAs), an HSA provides a perfect trifecta of tax benefits–that is, an HSA holder gets an income tax deduction for any contributions made, tax-deferred accumulation of earnings and interest on those contributions, plus tax-free distributions to pay for qualified medical expenses. In short (as long as the rules of the road are followed): tax-free contributions, accumulations and distributions can accrue to an HSA holder. Let’s take a look at each of these benefits.
Income Tax Deduction for Any Contributions Made
A participant making contributions to its 401(k) plan receives a state income tax deduction. However, the participant must still pay FICA taxes (as well as much smaller Federal Unemployment Tax Act taxes and, in most states, State Unemployment Tax Act taxes) on the amount of any contributions.
FICA taxes (7.65%) are comprised of amounts withheld for Social Security (6.20%) and those withheld for Medicare (1.45%). An employer that makes a contribution on behalf of a participant, such as a 401(k) match, must likewise pay FICA taxes for which the employer receives an income tax deduction.
But in the scenario where an HSA holder receives medical coverage through an employer-sponsored high deductible healthcare plan and defers HSA contributions through payroll deductions via an IRS section 125 cafeteria plan, any income tax-deductible contributions made by the holder to the HSA are also free of FICA (and other) taxes, just as any contributions made by an employer on behalf of the account holder are also free of such taxes.
So in the payroll deduction scenario, not only is an HSA holder able to avoid payment of FICA (and other) taxes on any contributions it makes, but its employer is also able to avoid payment of such taxes on any contributions that it makes on behalf of the account holder.
This is especially valuable to any HSA-contributing employer because, unlike the Social Security/disability 6.20% tax which is withheld on compensation only up to a 2017 wage base of $128,700 ($128,400 in 2018), the Medicare 1.45% tax has no such limit. (In cases where an employee earns more than $200,000 in a calendar year, the employer but not the employee must also pay a 0.90% Medicare surtax that’s withheld from the employee’s compensation.)
HSA Contributions by Lower Income Employees
A (relatively) well-heeled employee will be able to max out contributions to his HSA and also pay medical expenses out-of-pocket every year, so it makes sense to own an HSA. But what about lower income employees? Studies (and plain common sense based on the arithmetic of income and outgo) show that many such employees simply do not have much money set aside to cover even small emergency expenses. When they need medical care, often their first option is to not go to the doctor. Their next option may be to use a credit card to cover medical expenses. Neither is optimal.
Many lower income employees find it difficult to save much so they don’t open an HSA. Nonetheless, it’s still a good idea for such employees to do so. After all, 80% of employers offering an HSA in conjunction with a high deductible healthcare plan contribute $500 to $1,500 per employee through payroll deductions. Lower income employees able to kick in annually another $1,000 (or about $83 per month or about $42 per paycheck when paid twice a month) or $2,000 (or about $167 per month or about $84 per paycheck) will find themselves with a stake of $1,500 to $3,500 in the first year of the HSA.
Even if that stake were to be all used up on qualified medical expenses in the first year, HSA holders would still able to avoid putting that amount on their credit cards–and even more importantly, would be able to obtain and pay for medical attention.
One way or the other, we all inevitably incur qualified medical expenses. The question is, how should we pay for them? With a credit card or with an HSA yielding what can be thought of as a “guaranteed” investment return of 7.65% (or even up to nearly 13% in a state such as Pennsylvania which, in addition to the 7.65% FICA tax, requires a 3% state flat tax regardless of income plus a 2% payroll tax). Why forego such savings offered in an HSA under an employer’s 125 plan?
On the other hand, if the HSA kitty wasn’t touched at all in the first year, then that’s $1,500 to $3,500 available for an HSA holder to cover out-of-pocket costs in subsequent years. Further, employees do not have to be in any particular tax bracket to benefit from an HSA.
It’s not a stretch, then, to say that rather than HSAs offering a perfect trifecta of tax benefits, they actually offer a perfect “quadfecta” of tax benefits, with the fourth benefit being avoiding payment of 7.65% FICA taxes. Other tax benefits–although smaller–include avoidance of Federal Unemployment Tax Act taxes and, in most states, State Unemployment Tax Act taxes.
In sharp contrast to the payroll deduction scenario is the nonpayroll deduction scenario. This is when there’s an employer-sponsored high deductible healthcare plan and employees make, say, a lump sum contribution to their HSAs (or their employers do so on their behalf), but neither does so through payroll deductions. In both cases, the respective contributor is legally obligated to pay FICA (and other) taxes.
This outcome would be the same when employees establish their own HSAs without help from their employers; that is, an income tax deduction is allowed but not one for FICA (and other) taxes. Such employees who don’t contribute to their HSAs through payroll deductions at work must wait until tax time to get money reimbursed to them by claiming a deduction.
It’s vital for advisors who wish to enter the HSA marketplace to understand the most sequentially efficient way of contributing to an HSA and a 401(k) plan. That discussion will kick off next month’s column.
W. Scott Simon is an expert on the Uniform Prudent Investor Act, Restatement (Third) of Trusts and Title I of ERISA. He provides services as a consultant and expert witness on fiduciary investment issues in depositions, arbitrations and trials as well as in written opinions. Simon is the author of two books including The Prudent Investor Act: A Guide to Understanding. He is a member of the State Bar of California, a Certified Financial Planner® and an Accredited Investment Fiduciary Analyst™. Simon received the 2012 Tamar Frankel Fiduciary of the Year Award for his “contributions to advancing the vital role of the fiduciary standard to investors, capital markets and to society.” The author’s views expressed in this article do not necessarily reflect the views of Morningstar.