Are you deciding on employer-offered health insurance or calculating the right retirement plan contribution amounts for your nest egg? June and January are typically the months when companies offer open enrollment to their employees, a limited-window time when you can enroll in or change health insurance and retirement plans for the upcoming year. Health savings and flexible spending accounts may be available depending on the plans your employer offers. These two accounts can provide tax planning opportunities to lower your tax liability and increase your retirement plan funding.
A health savings account (HSA) can pay for qualified medical expenses of the account beneficiary or the beneficiary’s spouse or dependent(s). Contributions to an HSA are tax deductible as an adjustment to adjusted gross income (AGI) and may avoid payroll taxes if funded through an employer-sponsored plan. Your contributions remain in your account until you use them for qualified medical expenses.
The contribution deduction limit is subject to annual inflation. For 2017, you can contribute $3,400 individually and up to $6,750 for family coverage. If you are over age 55, you can contribute an additional $1,000 per year.
Proposed legislation recently approved by the House of Representatives would increase the HSA contribution limit to at least $6,550 for individuals and $13,100 for families beginning in 2018. This legislation faces uncertainty in the Senate. However, if it became law in its current state, besides the increased contribution limitations, HSA rules would become more flexible. Changes in this proposed legislation include an end to the ACA/Obamacare prohibition on paying for over-the-counter medications with HSA account funds and a reduction from 20% to 10% for the penalty imposed if funds from an HSA are used for non-qualified medical related expenses.
When opening an HSA, you will be asked to designate a beneficiary. The beneficiary you choose affects the taxation of the plan in the hands of your beneficiary upon your demise. For example, choosing a spouse as your beneficiary yields a tax-free transfer. The plan remains as an HSA and your spouse elects to treat the HSA as their own plan. If you choose a non-spouse beneficiary, the fair market value of the HSA must be included in the beneficiary’s income when the account is transferred.
A flexible spending account (FSA) offers the same tax savings and pretax benefits as an HSA if you are in a higher-cost health plan. However, you can use the funds for certain eligible over-the-counter medical expenses. The caveat is the contributions allowed to an FSA are much lower than HSAs. For 2017, you can contribute up to $2,600 for the plan year.
Another key difference is an FSA is a “use-it-or-lose-it” plan. Amounts remaining in your account at the end of the year generally cannot be carried forward into future years. Employer plans may provide a grace period of up to 2.5 months. Any qualified medical expenses during this period can be paid from amounts left in the account at year end. Plans may allow a carryover of up to $500 of FSA funds remaining at year end to be carried over to the following year.
The proposed legislation before the Senate would eliminate FSA contribution limits beginning in 2018.
The deductions and overall tax benefits provided by HSAs and FSAs can be used to lower your overall tax obligations, if you plan properly. Since contributions to these plans escape federal income tax, a taxpayer in the 25% tax bracket can save $300 in federal income tax and $77 in payroll taxes by contributing $100 per month, or $1,200 annually, to an employer sponsored HSA or FSA plan.
If you expect to incur these qualified health medical expenses, consider taking advantage of the tax-saving opportunities these plans offer; then consider using the extra savings to increase your retirement plan contributions. You likely can update your retirement plan contribution election during the same open enrollment period you elect to contribute to an HSA or FSA. Remember, a lot more goes into selecting plans during open enrollment than checking a box. Read the parameters of your plan closely to maximize your tax savings!