What is the only tax-deductible and tax-free investment not subject to IRS’ minimum distribution requirements and income limitations? While several possibilities come to mind, you will see shortly that there’s one clear-cut winner.
Let’s look at some candidates, starting with 401(k) plans. Traditional 401(k) plan contributions are deductible and grow tax deferred. Distributions are taxed as ordinary income and are subject to IRS’ required minimum distribution (RMD) rules. Forget that.
What about Roth 401(k) plan contributions? They grow tax deferred, distributions are nontaxable, and aren’t subject to RMD rules unless you inherit a Roth 401(k). One catch — there’s no deduction for contributions. I guess you can’t have everything.
How about traditional IRAs? The good news is that they grow tax deferred, however, that may be the only tax benefit. For starters, contributions may or may not be deductible depending upon whether you or your spouse, if married, are covered by a retirement plan at work and your income exceeds certain levels. In addition, 100% of deductible contributions and earnings are taxed as ordinary income when withdrawn with distributions subject to RMD rules.
So you’re not big on tradition, let alone traditional IRAs. You’ve heard that Roth IRAs are the ultimate investment. Like Roth 401(k) plan contributions, they have three income-tax advantages: tax-deferred growth, nontaxable distributions, and avoidance of RMD rules unless you inherit them. Unfortunately, contributions are always nondeductible. Furthermore, the ability to make contributions is subject to income limitations.
And the winner is …
Give up? Is there really an investment that’s tax deductible, tax free, and isn’t subject to IRS’s minimum distribution requirements and income limitations? Yes, there is. It’s called a health savings account, or HSA, and it’s been around since 2004.
Just like traditional 401(k) plan and deductible traditional IRA contributions, contributions to HSAs are pretax. You can take the deduction even if you don’t itemize deductions. In addition to reducing taxable income and income-tax liability like any other deduction, a pretax deduction provides two additional benefits: (1) Unlike itemized deductions, they’re not limited by income, and (2) they reduce modified adjusted gross income which is used for calculation of the Medicare earned-income-tax and Medicare investment-income tax.
Individuals who have employers who make contributions to their HSA receive an additional tax benefit. Unlike employer 401(k) plan contributions that are taxable when distributions are received, employer contributions to an HSA plan are excludable from gross income when contributions are made and when withdrawals are taken.
Deduct otherwise nondeductible medical expenses
In addition to realizing the foregoing income tax benefits not available with any other type of investment, HSAs enable you to convert otherwise nondeductible medical expenses into deductible expenses. Unless you have an HSA account, medical expenses are generally nondeductible since only the amount that exceeds a high threshold — 10% of adjusted gross income if 64 or younger or 7.5% of adjusted gross income if 65 or older (through 2016) — can be deducted.
How do you qualify for an HSA? There are four requirements as follows:
- Covered under a high-deductible health plan
- No other health coverage with limited exceptions
- Not enrolled in Medicare
- Can’t be claimed as a dependent on someone else’s tax return
Contribution limits, while adjusted for inflation and comparable to those for traditional and Roth IRAs, are on the low side, especially if you’re single and less than 55 years old. Assuming that you qualify, you can make a deductible contribution to your HSA account up to the following limits in 2015:
- $3,350 if single and less than 55 years old
- $4,350 if single and 55 or older
- $6,650 if married and less than 55 years old
- $7,650 if married and 55 or older
This sounds too good to be true. How can you receive a pretax deduction for contributions, have them grow tax deferred, and take distributions without paying income tax? This seems to defy IRS logic.
There is a catch. Distributions are tax free provided they’re used to pay for “qualified,” or eligible, medical expenses. These are expenses that would generally qualify for the medical- and dental-expense deduction. The most notable exception is insurance premiums unless they’re for long-term care insurance or health care continuation coverage such as COBRA. In addition, you cannot deduct qualified medical expenses as an itemized deduction if they’ve been paid from your HSA.
Withdrawals can be made from HSA accounts at any time so long as they’re used for qualified medical expenses; otherwise a 20% penalty will apply. The penalty is waived after you reach 65, however nonmedical expense related distributions will be taxable as ordinary income.
So what are you waiting for? If you don’t already have an HSA, you meet the eligibility requirements, and you want the optimal tax-advantaged investment, look no further. A health savings account is an underutilized hidden gem.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.