Reaping retirement plan benefits from the most tax-friendly retirement plan

Suppose you were asked to design the most taxpayer-friendly retirement plan possible. If given a choice, you would want a plan that allows for generous annual contributions. The contributions would be tax-deductible, regardless of whether or not you itemize deductions and regardless of your earnings or taxable income. Dividends, interest, capital gains and other income from the plan would be tax free. Distributions you receive from the plan could be taken whenever desired, regardless of your age. Finally, as you design your too-good-to-be-true retirement plan, there may be no taxation on the distributions you receive from the plan.

Believe it or not, the ideal retirement plan does in fact exist. It is called a Health Savings Account (HSA) which contains all of the features described above. Despite the meaningful benefits offered to taxpayers, HSAs remain underutilized and, even when implemented and funded by taxpayers, are often not operated in as tax-efficient of a manner as possible.

The general intention of HSAs is to permit taxpayers to contribute tax-deductible amounts to a separate account and withdraw the funds contributed for the payment of medical expenses. For 2023, the HSA deduction limit is $3,850 for individual coverage and $7,750 for family coverage. An additional tax-deductible contribution of $1,000 can be made by an individual who has attained age 55, as can an additional $1,000 contribution for a taxpayer’s spouse for family coverage.

HSAs do have some rules and restrictions, just like other retirement plans. HSA contributions can only be made by participants in high-deductible health plans. To qualify as a high-deductible health plan for the 2023 calendar year, the deductible must be at least $1,500 and the annual out-of-pocket expense limit must not exceed $7,500. For family coverage, the deductible must be at least $3,000 and the annual out-of-pocket expense limit cannot exceed $15,000. Moreover, the high-deductible health plan must generally be the only plan for which the taxpayer can be enrolled and the taxpayer may not be enrolled in Medicare. That being said, a taxpayer who participates in vision, dental, disability and/or long-term care insurance programs is not disqualified from HSA participation.

Distributions from HSAs are not subject to income tax to the extent the withdrawn funds do not exceed the medical expenses incurred. Qualifying medical expenses are those which are allowable as itemized deductions for income tax purposes. These include not only routine medical expenses for physicians and medical procedures but also medical expenses which are not covered by a standard health insurance plan such as vision and dental expenses.

One of the unique HSA features is the absence of timing rules specifying when HSA withdrawals must be made. A taxpayer could, for example, incur a medical expense in one year and withdraw funds from the HSA in one or more subsequent years attributable to the medical expenditure in the prior year. There is no requirement that the HSA withdrawals be made by a specified date for expenses incurred in a particular year. The absence of withdrawal rules is distinguishable from pension plans, profit sharing plans, 401(k) plans and IRAs which require that distributions commence by specified dates and continue during the participant’s lifetime and after the participant’s death.

HSA participants tend to withdraw funds as and when medical expenses are incurred and, as a result, are missing out on a big opportunity. The better technique for taxpayers who can afford to do so is to pay medical expenses from personal funds and postpone withdrawals to reimburse themselves for medical expenses incurred, thereby allowing HSA funds to continue to earn returns on a tax-deferred or tax-free basis. With the proliferation of HSA accounts in recent years, there are a growing number of investment institutions offering not only money market accounts but investments in a broad selection of equity and other mutual funds which can enable HSA participants to enjoy enhanced growth in their accounts.

Employers sponsoring health insurance plans for employees should consider offering a high-deductible plan option. If a high-deductible health plan is made available as an option to employees, those who can afford to do so will enjoy utilizing an HSA and its tax benefits. At the same time, employees with significant cash flow needs may neither desire nor be able to take advantage of the tax savings opportunities that are available with high-deductible health plans and can elect to participate in a health plan option with a lower deductible. Both employers and employees who share the cost of employees’ health insurance premiums will usually experience lower premium costs with a high-deductible plan. This may permit employees to utilize the premium savings to fund their own HSAs while employers may choose to utilize some or all of the premium savings to make HSA contributions on behalf of their employees. Together, both employers and employees can take advantage of this most desirable opportunity.

As with many too-good-to-be-true tax planning opportunities, HSAs may not be available in their present form forever. The savvy taxpayer will no doubt want to take advantage of the opportunity while it is available.

Please contact Bruce Bell with any questions at (312) 648-2300 or e-mail at bruce.bell@sfbbg.com.

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