Tax Guy: I’m newly self-employed. Should I open a health savings account?

According to a recent report by Devenir (an HSA investment provider), HSA assets grew to about $98 billion as of 12/31/21, held in about 32 million accounts. That was a year-over-year increase of 19% for assets and 8% for accounts. Devenir projects that by the end of 2024, there will be about 38 million HSAs with assets approaching $150 billion.

Back in 2010, the Employee Benefit Research Institute reported that there were 5.7 million HSAs with account balances totaling $7.7 billion. Wow. HSAs are obviously gaining ground at a rapid clip. 

The basics of health savings accounts (HSAs)

Under the Affordable Care Act (also called Obamacare), health insurance plans are categorized as Bronze, Silver, Gold, or Platinum. Bronze plans have the highest deductibles and least-generous coverage and are therefore the most affordable. Platinum plans have no deductibles and cover much more, but they are also much more expensive. In many cases, the ACA led to big premium increases even for those who prefer less-generous plans. However, having a not-very-generous plan might make you eligible to open up and contribute to an HSA with the resulting tax advantages.     

For the 2022 tax year, you can make a deductible HSA contribution of up to $3,650 if you have qualifying self-only coverage or up to $7,300 if you have qualifying family coverage (anything other than self-only coverage). 

For 2023, the maximum contributions will be $3,850 and $7,750, respectively. If you are age 55 or older as of yearend, the maximum contribution goes up by $1,000. 

You must have a qualifying high-deductible health insurance policy and no other general health coverage to be eligible for the HSA contribution privilege. For 2022, a high-deductible policy is defined as one with a deductible of at least $1,400 for self-only coverage or $2,800 for family coverage. For 2023, the minimum deductibles will be $1,500 and $3,000, respectively.  

For 2022, qualifying policies can have out-of-pocket maximums of up to $7,050 for self-only coverage or $14,100 for family coverage. For 2023, the out-of-pocket maximums will be $7,500 and $15,000, respectively. 

Key point: For HSA eligibility purposes, health insurance premiums do not count as out-of-pocket medical costs.  

Tax treatment of HSA contributions 

If you are eligible to make an HSA contribution for the tax year in question, the deadline is April 15 of the following year (adjusted for weekends and holidays) to open an account and make a deductible contribution for the earlier year. So, there is still plenty of time for an eligible individual to open an account and make a deductible contribution for 2022, because the deadline is 4/17/23. 

The write-off for HSA contributions is an above-the-line deduction. That means you can take the write-off even if you don’t itemize. More good news: the HSA contribution privilege is not lost just because you happen to be a high earner. If you are covered by qualifying high-deductible health insurance, you can make contributions and collect the resulting tax savings. Even self-employed billionaires can contribute if they have qualifying high-deductible health insurance coverage and meet the other eligibility requirements explained below.  

Key Point: Sole proprietors, partners, LLC members, and S corporation shareholder-employees are generally allowed to claim separate above-the-line deductions for 100% of their health insurance premiums, including premiums for high-deductible coverage that makes you eligible for HSA contributions. 

Example 1: You and your spouse are a married joint-filing couple. You are both self-employed, and you each have separate HSA-compatible individual health insurance policies for all of 2022. Both policies have $2,000 deductibles. For the 2022 tax year, you and your spouse can each contribute $3,650 to your respective HSAs and thereby claim a total of $7,300 of tax-saving write-offs on their 2022 joint Form 1040. If you are in the 24% federal income tax bracket, this strategy cuts your 2022 tax bill by $1,752 (24% x $7,300). If you run this drill for 10 years, you will save $17,520 in federal income taxes — assuming you contribute $7,300 each year and remain in the 24% bracket. You may also be entitled to state income tax savings. Plus, you will have whatever has accumulated in your HSA balances. 

Example 2: For all of 2023, you will have qualifying family health insurance coverage with a $4,000 deductible. You will be 55 as of 12/31/23, so you can contribute up to $8,750 to an HSA for the 2023 tax year — the “normal” $7,750 limitation + $1,000 extra due to your age.    

Tax treatment of HSA distributions

HSA distributions used to pay qualified medical expenses of the HSA owner, spouse, or dependents are federal-income-tax-free. However, you can build up a balance in the account if contributions plus earnings exceed withdrawals for medical expenses. Any earnings are federal-income-tax-free. So if you are in very good health and take minimal or no distributions, you can use an HSA to build up a substantial medical expense reserve fund over the years while earning tax-free income all along the way. 

If you still have an HSA balance after reaching Medicare eligibility age (generally age 65), you can drain the account for any reason without a tax penalty. If you don’t use the withdrawal to cover qualified medical expenses, you will owe federal income tax (and maybe state income tax), but the 20% tax penalty that generally applies to withdrawals not used for medical expenses will not apply. There is no tax penalty on withdrawals after disability or death.  

Alternatively, you can use your HSA balance to pay uninsured medical expenses incurred after reaching Medicare eligibility age. If your HSA still has a balance when you depart this cruel orb, your surviving spouse can take over the account tax-free and treat it as his or her own HSA — provided your surviving spouse is named as the account beneficiary. In other cases, the date-of-death balance of the HSA must generally be included in taxable income on that date by the person who inherits the account. 

Warning: HSA funds cannot be used to make tax-free reimbursements for medical expenses that were incurred before the account was opened. 

HSA investment options and providers  

In some important ways, HSAs are similar to IRAs. Both have the same contribution deadlines, both need an account custodian or trustee, and both can theoretically offer the same investment options (stocks, mutual funds, bonds, CDs, and so forth). That said, some HSA trustees may limit your investment choices to very conservative options, which is not necessarily a bad thing. 

You can find an HSA trustee with an internet search. Some health insurance companies and brokerage firms have pre-arranged deals with HSA trustees. For example, Vanguard customers can move funds into HSAs operated by a vendor partner called HealthEquity.   

The bottom line

An HSA can work a lot like an IRA if you can maintain good health and avoid big medical bills. Even if you have to drain the account every year to pay for uninsured health costs, the HSA arrangement allows you to make annual deductible contributions and pay for uninsured expenses with pretax dollars. These tax benefits can add up to substantial bucks over the years. So, if you are eligible for an HSA, starting one up and making annual deductible contributions is a no-brainer, IMHO.