With traditional retirement accounts, you typically have the option of paying taxes now or paying taxes later. To truly optimize your choice between these two options, you would need to know your tax bracket in retirement. That’s because the bet you make when deciding between the traditional IRA or 401(k) and the Roth IRA or Roth 401(K) all depends upon your tax bracket in retirement as compared to your tax bracket today.
If your tax bracket in retirement is lower than it is during your working years, you are better off saving money in a traditional IRA or a traditional 401(k) plan. However, if your tax bracket in retirement is higher than it is during your working years, you are better off saving money in a Roth IRA or a Roth 401(k).
With a Health Savings Account (HSA), you have a far-superior option: you don’t pay taxes at all. An HSA allows you to claim a tax deduction with the initial contribution to your HSA and then withdraw that money tax-free when you use it to cover qualified medical expenses in the future.
While you could use your HSA as a specialized savings account by simply leaving the money in the account until you need it for medical bills, the real benefit comes when you use it as an investment vehicle for your retirement. Most HSA providers allow you to invest the funds within your account, and the earnings on your investments will grow tax-free as long as the proceeds are used for medical expenses.
Example: The table below shows that a taxpayer in the 24% tax bracket would be indifferent between the Roth IRA and the traditional IRA if their marginal tax bracket in retirement (24%) is also 24% during their working years. In order for the Roth to benefit the taxpayer, their marginal tax bracket must be higher in retirement than what it is during their working years.
Benefit of the HSA Relative to the Roth or Traditional IRA: $7,500
This example is for illustrative purposes only. This example assumes an approximate 8% return on invested capital and there is no guarantee that your investment will earn this return, or any return.
Qualifying for a Health Savings Account
The biggest drawback to Health Savings Accounts is you can only contribute to one while you are covered under a High-Deductible Health Plan. A High Deductible Health Plan is a health insurance plan that meets specific requirements for deductibles and out-of-pocket maximums. For 2021 these thresholds are:
Deductibles of at least $1,400 for individual coverage or $2,800 for family coverage
Out-of-pocket maximums that do not exceed $7,000 for self-only coverage or $14,000 for family coverage
If your health insurance plan meets these criteria you are eligible to contribute to a Health Savings Account. There are no income limitations on HSA contributions.
For 2021, if you have a qualifying health plan you can contribute up to $3,600 if you have an individual health plan or $7,200 if you have a family health plan. Married couples can each have their own HSA, but their combined contributions cannot exceed $7,200. If you are over the age of 55 you can make an additional catch-up contribution of $1,000.
Save on Payroll Taxes with Paycheck Contributions
If your employer offers an HSA, you can make contributions directly through your paycheck. This option provides additional tax savings because contributions you make through salary reductions reduce your Social Security and Medicare taxes in addition to your income taxes. Going back to our example above, if you contributed $6,500 through salary reductions you would reduce your Social Security and Medicare taxes by $497. As an added bonus, some employers may match your contributions to your HSA.
If your employer does not offer an HSA, you can set up an account yourself and make contributions to it. Many banks and other financial institutions offer Health Savings Accounts.
Using Your HSA to Cover Your Medical Expenses
You can use your HSA to pay qualified medical expenses, including doctor’s bills, hospital bills, dentist bills and prescriptions. You cannot use your HSA to pay your health insurance premiums. However, once you turn 65 you can use your HSA to pay your Part B and Part D Medicare premiums.
To use your HSA, you can pay your medical expenses directly out of your HSA account (many HSA providers will give you a debit card to make direct payments) or you can pay with your normal debit or credit card and then reimburse yourself by taking money out of the HSA.
There is no time limit to reimburse yourself out of your HSA. You can pay a medical bill today and reimburse yourself from your HSA 20 years from now for that bill. This allows you to keep money in your HSA as long as possible to take advantage of tax-free growth if you invest the funds in your account.
You will need to keep track of your qualified expenses so that you can reimburse them down the road. Many HSA providers will allow you to upload receipts through their website so you can easily keep track of your medical expenses until you choose to pull out the funds for reimbursement.
If you reimburse your medical expenses from your HSA, you cannot claim an itemized deduction for those expenses on your tax return. However, this is a small price to pay as the limitations placed on itemized deductions for medical expenses make them worthless for the vast majority of taxpayers.
If there is one thing you can count on during your retirement years, it’s high medical expenses. The cost of health care is increasing faster than nearly all other sectors of the economy. If you are covered under a High-Deductible Health Plan, a Health Savings Account is one of the best tools at your disposal because it provides tax savings today and tax-free distributions in retirement when used to cover your medical expenses.
For more information on HSA’s you can read our article: “Six Myths About Health Savings Accounts”
This article is a general communication being provided for informational and educational purposes only and is not meant to be taken as tax advice, investment advice or a recommendation for any specific investment product or strategy. The information contained herein does not take your financial situation, investment objective or risk tolerance into consideration. Readers, including professionals, should under no circumstances rely upon this information as a substitute for their own research or for obtaining specific legal, accounting or tax advice from their own counsel. Any examples are hypothetical and for illustration purposes only. All investments involve risk and can lose value, the market value and income from investments may fluctuate in amounts greater than the market. All information discussed herein is current only as of the date of publication and is subject to change at any time without notice. Forecasts may not be realized due to a multitude of factors, including but not limited to, changes in economic conditions, corporate profitability, geopolitical conditions, inflation or US tax policy. This material has been obtained from sources believed to be reliable, but its accuracy, completeness and interpretation cannot be guaranteed.
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