391 / What are the advantages of an HSA?

(1)     Federal Income Tax Deduction. HSA contributions reduce an account owner’s income for federal income tax purposes because personal HSA contributions are tax deductible and employer contributions are received on a pre-tax basis (see Q 397).

(2)     State Income Tax Deduction. Most states with income taxes allow account owners to reduce state taxable income by the amount of an HSA contribution. California, New Jersey and Alabama are the only states that do not allow a state income tax deduction for an HSA contribution. All other states have either passed specific legislation allowing HSA deductions for state income tax purposes, have conforming legislation where the federal deductions flow through at the state level, or do not have a state income tax.

(3)     Payroll Tax Avoidance. Account owners receiving HSA contributions pre-tax through an employer, whether they are employer contributions or employee payroll deferral through a Section 125 plan, avoid Social Security taxes, Medicare taxes (together with Social Security referred to as FICA), federal unemployment taxes (FUTA), Railroad Retirement Act taxes, and in most cases state unemployment taxes (SUTA) (see Q 418).

(4)     Tax Deferred Earnings Growth. Any interest, dividends or other appreciation of the assets in an HSA grow tax-deferred while in the HSA (see Q 410).

(5)     Tax-free Distributions. Account owners that use HSA funds for qualified medical expenses enjoy tax-free distributions (see Q 411). If the funds will be used to pay for qualified medical expenses, the HSA rules are more advantageous than the tax treatment provided to distributions from traditional IRAs or 401(k)s because those plans are only tax-deferred, not tax-free (although Roth IRA and Roth 401(k) distributions are tax-free, as contributions are made with after-tax dollars).

The non-tax benefits of HSAs are also significant, and include the following:

(1)     Balance Rolls Over. HSA balances roll over from year to year and do not have “use it or lose it” restrictions that apply to other medical spending account plans.

(2)     HSA Remains after Separation from Service. An HSA remains with the account owner after separation from service even if the employer provided the HSA funding.

(3)     Transferability. Account owners can move their HSA to a new HSA custodian at any time (see Q 413).

(4)     Ownership. HSA account owners own the money in their HSA and can use it as they see fit. This relates to other benefits already mentioned, but also provides account owners the ability to name beneficiaries on the account, select investments, and decide when to take a distribution (even if the distribution is for a nonmedical reason). Note that the penalty tax for non-qualified distributions does not apply once the taxpayer has reached age 65.

(5)     Control Spending. An HSA gives account owners some additional control over their medical spending. The account owner can decide where to spend the money and can negotiate with providers when appropriate. This gives the account owner some freedom to choose medical providers outside of an insurance company’s network or to try alternative approaches (within the definition of “qualified medical expense”).

(6)     Lower Insurance Premiums. HDHPs (which must be used in order for the individual to qualify for an HSA) are generally less expensive than traditional insurance.