Tax Insight

The Best Deal in the Tax Code – Health Savings Accounts

Health Savings Accounts (HSAs) are a special kind of savings account that is set up specifically for medical expenses. In order to encourage people to save for medical expenses, lawmakers allow individuals to claim a tax deduction from their income when they contribute funds to an HSA, much like with an IRA. Each dollar contributed to the savings account will reduce Adjusted Gross Income (AGI) and taxable income.

There are some important differences between an HSA and an IRA. First, money in an HSA can be withdrawn tax-free at any time, as long as it is used for qualified medical expenses. This is significant, because it means that the money contributed to an HSA is never taxed – not when it was contributed (because of the deduction) and not when it is withdrawn. There is no other arrangement in the tax code that is treated so favorably. Additionally, the unique set of rules which govern HSAs provide a rare “double berry” opportunity in the tax code.

Generally, medical expenses can only be deducted from your taxable income if you itemize deductions. Those who claim the standard deduction cannot receive any tax benefit from those expenses. Even if you itemize, you can only deduct those medical expenses that exceed 7.5% of your AGI (or 10% if you are subject to the alternative-minimum-tax [AMT]).

Example: James has an AGI of $80,000 and had $6,500 in medical expenses. He is only able to deduct $500 of those expenses (7.5% × $80,000 AGI = $6,000 non-deductible expense → $6,500 expenses − $6,000 non-deductible = $500 deductible). If James were subject to the AMT he would get no deduction because his expenses would not exceed the non-deductible amount (10% x $80,000 = $8,000 non-deductible).

There is a way, however, that you can deduct many of these “non-deductible” expanses. You must first have a qualifying high-deductible health insurance plan. With such an insurance policy in place, you can contribute up to $3,050 ($6,150 for families) to an HSA. In doing so, every dollar contributed is deductible. Then, you can use those funds tax-free to pay for medical expenses. In this way you can circumvent the itemization requirement and not have to get over the 7.5 or 10% of AGI hurdle.

Tip: An additional benefit to these contributions is that the AMT has no effect on your ability to claim the deduction, as it does when itemizing. In fact, the AMT is reduced when claiming this deduction.

Tip: If you are over the age of 55 you can contribute an additional $1,000 over those limits as a “catch-up” contribution. 

While the money is in the HSA it can be invested and grow tax-free. When the money is needed it can be withdrawn tax-free, as long as it is used for medical expenses. If the money in the savings account is not used for medical expenses, it can be used for any expenses once you reach retirement age, which for this purpose is considered 59½. If used in for non-medical expenses after age 59½, income taxes will be due for the amount withdrawn in the same way that all retirement accounts are taxed.

Tip: Contributions to an IRA or 401k do not limit your ability to contribute to an HSA. If you have made the maximum contribution to an IRA, this could be a great way to significantly increase the contribution that you can make into an IRA-like account. Additionally, there is no high-income cap on HSA contributions. High income earners who may not be allowed to make contributions to IRA are able to contribute to HSAs.

In order to take advantage of this strategy, you must first ensure that you have a qualifying high-deductible health insurance plan. The best way to find that out is to contact your insurance company or your HR department. Once you have the right plan, then you must set up an HSA account with a provider. Many large banks offer HSA accounts. They will usually give you a special debit card for the account, which makes it very easy to access the funds when you need to pay a bill. Once you have the right plan and the account, contribute all that you can to the account, up to the maximum allowed.

Tip: If you need to switch insurance plans in order to qualify for an HSA, there is a very good chance that the money you save in premiums will add up to a large portion of the maximum HSA contribution. Put at least the amount that you save in premiums each month into the HSA.

If your budget is really tight, then at least contribute to the HSA as you have medical expenses. If a doctor bills you for $150, send the $150 to your HSA first, and then pay the doctor from that account. Doing so will usually bring a greater tax benefit than by paying the doctor from funds outside of the HSA account.

Tip: In the scenario above, you are ensuring that each dollar you pay in medical expenses becomes a deduction. If paid out of pocket, not through the HSA account, the expenses will be limited by the itemization thresholds.

There is a way to have your cake and eat it too, when it comes to HSA accounts and itemized medical deductions. Here is what to do:

• Contribute the full amount allowable to your HSA in order to have maximum deduction.
• Do not take any money out of the HSA for medical expenses that you incur – just leave all of the funds in the HSA.
• Allow the contributions to grow tax free for the future.
• Pay all of your current medical expenses out of pocket. Included in those expenses is the cost of your health insurance premiums (which cannot be paid from the HSA).

By following these steps you will get a deduction for the HSA contribution, another deduction for expenses over 7.5% of AGI (including premiums), and tax free growth on your HSA account. Is that not beautiful?

Here are the things to know in order to get the full benefit of this strategy and avoid the pitfalls:

• Like an IRA, you can make HSA contributions up to April 15th of the following year.
• Do not contribute more than the maximum allowable to an HSA—there are fairly steep penalties if you do.
• Do not use the HSA funds for anything that is not a qualified medical expense. If you do you will pay taxes on the amounts used, as well as a 10% penalty if you are younger than 59½. Beginning in 2011 the penalty will increase to 20%.
• Beginning in 2011 you cannot use funds from an HSA to purchase over-the-counter medications, unless they are prescribed by a doctor. You can use them, however, for un-prescribed medical equipment that qualifies under the tax code.
• Keep records of your medical expenses that you pay for using funds from your HSA.
• It is possible that you (and your spouse) may not be eligible for an HSA because of an employer-sponsored health plan, unless it is an HSA plan.
• Ensure that your insurance plan meets all of the necessary qualifications.

Deduct Property Taxes Without Itemizing

A great post on FrugalRealEstate explaining how you can deduct your property taxes even if you’re not itemizing your deductions.  Don’t miss this one!  How do we calculate the value of this deduction?  Remember from the tax course (specifically regarding the Myth of Deductions) that it’s the cost of the deduction * your marginal tax rate.

Use our income tax calculator to get your marginal tax rate.  For our quick example, let’s assume you paid $2,000 in property taxes and your marginal tax rate (the tax you’ll pay on the next dollar earned) is 25%:

$2,000 * 25% = $500

The deduction is worth $500 in tax savings.  Certainly not amount to scoff at!  Thanks to FrugalDad on Twitter for pointing out the article.

81 Days Left for Energy Saving Improvements

Are you making or planning energy-saving improvements to your home this year?  If so, it is important for you to know that the improvements must be installed by December 31^st in order to claim the tax credit.

There is a special tax credit available for homeowners who upgrade the energy efficiency of their residence.  The credit is the equivalent of 30% of the cost of the improvement, up to a maximum credit of $1,500.  That means that the credit is available on the first $5,000 of improvements ($5,000 x 30% = $1,500 max credit).  The maximum credit applies to 2009 and 2010 combined.  So if you claimed $1,000 in 2009, for example, you would only have $500 of credit still available for you to claim in 2010. The credit is non- refundable, does not carry forward into subsequent years, and cannot be used against the alternative-minimum tax.

There are many ways in which to improve your home’s energy efficiency that qualify for the credit.  You can install a high efficiency furnace, air conditioner or water heater.  You can also install skylights, new outside doors or windows.  Installing insulation qualifies. Even certain roofing materials will qualify for the credit.  Be sure that the specific improvement that you are making will qualify before buying it.

So, if any of these improvements are on your near-term list, get them taken care of right away so that you can claim the credit as well.   Make your holiday season nicer, as well as you local contractors, and then have the added bonus of fewer taxes next spring.