HSAs Offer Path to Tax Deduction

Susan Dziubinski: Hi, I'm Susan Dziubinski with Morningstar. Tax season is here, and one way that taxpayers may be able to reduce their tax bills is by making a contribution to a health savings account. Joining me today to talk about the ins and outs of these contributions is Christine Benz. Christine is Morningstar's director of personal finance.

Hey, Christine. Thank you for being here today.

Christine Benz: Hi, Susan. It's great to be here.

Dziubinski: Now, the deadline for making a contribution to an HSA for 2020 is April 15, just as it is with an IRA. So, can anyone make a contribution to an HSA?

Benz: No. You need to be covered by a high-deductible healthcare plan, and it needs to be a qualifying high-deductible healthcare plan. So, not all high-deductible healthcare plans are automatically qualified to be used with a health savings account. But if you were, you are able to make a contribution. One hitch, though, Susan, and people sometimes run into this--if you're covered by Medicare, you are not eligible to contribute to an HSA. So, just bear that in mind if you're Medicare-eligible or already covered by Medicare.

Dziubinski: Let's go over what the tax benefits are if you are in fact covered by a qualifying high-deductible plan.

Benz: Well, there are three, and they're really great tax benefits. The key is, tax-free contributions going in, so you're making pretax contributions if you're contributing to your employer-provided health savings account. If you are contributing to an HSA on your own, you're able to deduct that contribution on your tax return. That's what's called an "above the line deduction," so it reduces your adjustable gross income, so tax break on the way in. If you have the money invested in something and it produces income, you don't pay any taxes on that income as long as the money stays inside the HSA. And then, so long as you use your withdrawals to cover qualified healthcare expenditures, those monies are also tax-free. So, really tax-free every step of the way provided you follow the rules. And that's one reason we often say this vehicle is unparalleled in the whole tax code because you don't get those three tax breaks with any other vehicle other than an HSA.

Dziubinski: So, Christine, what are the contribution limits to an HSA? And can you make a partial contribution?

Benz: Yes, you can make a partial contribution. So, I'll get that out of the way first. For 2020, assuming that people want to try to get a contribution in at the last minute, the contribution for individuals covered by an individual high-deductible plan is $3,550. It's double that if you have a family plan, so $7,100 for 2020. And like with IRAs, we often see those numbers go up a little bit from year to year. So, for 2021, it's going up to $3,600 for people with single-only coverage and $7,200 for people with family coverage.

Dziubinski: We're specifically talking about HSAs, or health savings accounts, but there are also flexible savings accounts. If an investor is going to put a contribution into an HSA, can he or she also contribute to an FSA? And what are the differences?

Benz: Yeah, really good question, Susan, and a common point of confusion. So, if you are covered by a high-deductible plan, you're contributing to a health savings account, you are limited to what's called a "limited purpose" flexible spending arrangement. So, you can use an FSA, but that FSA can only be used to cover dental and vision expenses, basically. So, I think that there is an opportunity for people who really want to take maximum tax advantage of the health savings account to also use the FSA to kind of carve out a fund or an account where they will fund it to the level that they know they'll spend on vision and dental expenses in the year ahead. I do think there's an opportunity to use the two vehicles together, and you probably would want to think about doing that if you have any vision or dental expenses at all or expect to have them and you also want to try to leave the money in your HSA so that it can roll over from year to year.

The key distinction between the two type of vehicles from my vantage point is that HSAs, health savings accounts, you can get those monies invested, you can put them in mutual funds, ETFs, get the money invested and leave it there, ideally, because the money rolls over from year to year. You don't have to liquidate the account each year. With a flexible spending arrangement, usually, you do have to spend those funds on a year-by-year basis. People often say it's "use it or lose it," and that's largely true. You might have a little bit of a grace period. So, you want to be careful not to overfund your flexible spending arrangement because you can't generally carry the whole account or the whole amount of assets you have in the account forward.

Dziubinski: Now, if your employer offers an HSA, is it generally a good option for you to take it?

Benz: Well, it's definitely more seamless because you'll be able to contribute to the HSA rather painlessly, just through your payroll deductions. And it's also seamless from a tax standpoint, so you don't have to go to the extra step of deducting it on your tax return. If you're not covered by an employer healthcare plan, if you're buying your own healthcare coverage, you will have to deduct your HSA contribution on your tax return.

But I do think it's important for people who are covered by an employer plan to do their due diligence on the quality of the plan because definitely these plans are not created equally. I think they've gotten better, but you still have some very high-cost plans. You have plans with a lot of transaction fees along the way. Do your homework. If you determine that your employer-provided plan is not that hot, well, you have a workaround in that you can go ahead and contribute to it and then periodically transfer to another HSA of your own choosing. You can have more than one HSA up and running at any given point in time. So, I think that's kind of a neat strategy. You're not captive to your employer-provided HSA. You do have some wiggle room.

Dziubinski: If you do want to pursue that strategy and seek out an HSA on your own that you could funnel this money into, what should investors be aware of or looking for?

Benz: Well, one thing I think that they should pay attention to is that Morningstar has begun rating the biggest health savings accounts. So, annually, we've been taking a look at these accounts. And we have been looking at them from the standpoint of two major use cases. We know that people either use their HSAs as kind of "spend as I go" type vehicle where I'm pulling money from it to cover my healthcare costs as I incur them. So, we look at HSAs from that standpoint, and two different HSAs came out on top in the 2020 look at HSAs. Fidelity's was a top performer, as was Lively's for people who intend to use their HSAs as kind of a "spend as I go" vehicle. For people who want to try to wring the maximum tax benefits from their HSA, Fidelity's also came out on top from that standpoint. But definitely do your homework. Look at fees. If you're using the savings account option, look at interest rates. They're all pretty low right now, but presumably they'll change a little bit, maybe get better in the future. If you are investing, you definitely want to look at the quality of the investment options.

Dziubinski: Well, Christine, thank you so much for your time today and helping us navigate the HSA landscape. It's an interesting area for those of us who do have access to one.

Benz: It is, Susan. Thank you so much.

Dziubinski: I'm Susan Dziubinski with Morningstar. Thank you for tuning in.