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HSA Tax Benefits Often Overlooked

Educating employees about the many advantages of using health savings accounts is key

July 1, 2016 | John Scorza

Some employers might not realize it. And certainly, many employees aren’t aware. But health savings accounts (HSAs) come with attractive tax benefits.

“There’s a lot of confusion out there” about HSAs, said David Lindgren, compliance officer with Flexible Benefit Service Corp. in Rosemont, Ill. That's why it’s incumbent on employers to educate employees about all the advantages of HSAs. “Education is key,” he said.

HSAs, which were introduced in 2004, are used to pay for medical costs with pretax dollars and can be funded by employers, individuals (including family members and friends on someone’s behalf) or both. To encourage participation, employers can match employee contributions.

Triples Tax Advantages

“I personally believe the best way to make contributions is through payroll deductions,” said Lindgren, citing the resulting tax advantages. Under that approach, contributions are tax-free, avoiding federal and state income taxes and FICA taxes in most states. Additionally, money earned through HSA investments is not taxed and there is no tax on funds withdrawn to pay for qualified medical expenses.

That triple-tax advantage is “one of the most powerful things about HSAs,” Lindgren said.

To use an HSA, a person must:

Be covered by a high-deductible health plan (HDHP) that meets annual minimum deductible requirements.
Be a U.S. taxpayer.
Not be covered by another qualified health plan.
Not be claimed as a dependent by another person.

HSAs are subject to annual contribution limits that are adjusted yearly. People over the age of 55 can make an additional $1,000 catch-up contribution every year.

HSA funds can be invested in typical vehicles, such as stocks, bonds and mutual funds. There is no cap on account balances. “The sky’s the limit,” Lindgren remarked. Additionally, HSAs are portable—employees take the money in their accounts with them when they leave. Funds can be used to pay for qualified medical expenses for spouses and dependent children, too; that’s the case even after individuals become ineligible to contribute to HSAs because, for example, they’re no longer enrolled in an HDHP.

Qualified expenses include things such as:

Deductibles.
Co-insurance.
Prescription drug costs.
Dental fees.
Eyeglasses.
Lab fees.
Orthodontia.

HSAs cannot, however, be used to pay for health plan premiums.

If HSA funds are used to pay for nonqualified expenses, income taxes apply and a 20 percent penalty is imposed. Nonqualified expenses include items like:

Cosmetic procedures.
Teeth whitening.
Toiletries.
Over-the-counter drugs (without a prescription).
Weight-loss programs (unless being used to treat a specific condition).

As health insurance costs rise, employers have been shifting the burden to employees through consumer-driven plans, higher deductibles and co-pays. That leaves them on the hook for more out-of-pocket costs. So, Lindgren asked, why not give employees the option to pay for these expenses in a tax-free, cost-efficient way—with HSAs?

HSAs vs. 401(k)s: The Payroll Tax Advantage

According to IRS guidance, "The employer contributions [to an HSA] are not subject to withholding from wages for income tax or subject to the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), or the Railroad Retirement Tax Act." As a post from Tango Health clarifies, "A pretax contribution to an HSA is one made by your employer, either as part of your benefits plan, or as a deduction from your paycheck which you directed to your HSA. In either case, the money comes from your employer prior to payroll taxes (such as FICA and FUTA) and federal income tax withholding being applied."

Note that this differs from the treatment of pretax salary deferrals for a traditional 401(k) plan; those contributions are not taxed as income but are subject to payroll taxes (FICA/FUTA).

John Scorza is associate editor of HR Magazine.

Related Resource:

HSA Rules Get Tricky Once You Hit Age 65, Ed Slott and Co.

Related SHRM Articles:

401(k) Contributions 'Crowded Out' by HSAs—Does It Matter?, SHRM Online, February 2021

Employees Still Perplexed by HSA Plans During Open Enrollment, SHRM Online, November 2020

IRS Announces 2021 Limits for HSAs and High-Deductible Health Plans, SHRM Online Benefits, May 2020

Health Care Consumerism: HSAs and HRA, SHRM Online, May 2020

Are employer contributions to an employee’s health savings account (HSA) considered taxable income to the employee?, SHRM HR Q&As, October 2018