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Health Savings Account: A Tax-Deduction Trifecta

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March 11, 2015

Tax breaks sometimes hide in unexpected places. Did you know there are three—count 'em, three—tax deductions in health savings accounts (HSA)?

And the best news—it's not too late to claim those deductions for filing-year 2014.

"When it comes to taxes, no other savings account gives you the benefits that an HSA does," said Jackie Perlman, principal tax research analyst at The Tax Institute at H&R Block.

A health savings account is used to pay out-of-pocket medical expenses, including doctor visits, hospital and surgical expenses, dental work, prescription medicines, and eyeglasses. The money can grow from year to year—it's not a “use or lose it” situation like the Flexible Spending Account—and there’s no waiting period or deadline for qualified withdrawals.

The money you contribute is pre-tax or tax deductible, the account growth is tax free, and the withdrawals, as long as they are for qualifying medical expenses, are also tax free, Perlman explained. But watch out: If you use your HSA funds for something besides qualified health expenses, there is a 20% penalty.

Who Qualifies?

As the health care insurance landscape continues to change, some individuals are opting for a high-deductible health plan (HDHP). For 2014, your plan would need to have a minimum annual deductible of $1,250 for self-only coverage or $2,500 for family coverage to qualify. Taxpayers must have a qualified HDHP in order to contribute to a HSA. If you aren't sure if your plan qualifies, ask your insurer.

How Does It Work?

Taxpayers with a qualified HDHP can make contributions for their 2014 tax return until April 15, 2015. For 2014, taxpayers with self-only coverage may contribute up to $3,300 to their HSA. Those with family coverage may contribute up to $6,550. Those 55 or older (by the end of the tax year) can toss in an extra $1000 contribution per tax year.

Consider this: A taxpayer in the 25% marginal tax rate bracket contributes $2,000 to her HSA. Because that contribution is made pre-tax, she saves the marginal tax rate on her contribution, or up to $500. Then, if her HSA grows, say, even 1%, that $20 is tax free. Now the taxpayer has $2,020 to spend on qualifying medical expenses that she can use without paying taxes on the distribution.

"Unlike IRAs, an HSA does not have a waiting period before you can make tax-free withdrawals. Taxpayers with an HSA can even reimburse themselves for previous unreimbursed medical costs at any time, as long as the expenses were incurred after the HSA was established," Perlman said.

Healthy Growth?

Another benefit of the HSA is that you can keep the money growing in the account longer term. For instance, there are accounts in which you can invest in securities that a growth-oriented investor typically chooses, like stocks, mutual funds, exchange-traded funds (ETFs), or other investments. Of course, any time an investor uses these securities, they need to keep in mind that there's no guarantee of growth, and that the account could actually lose value.

An apple a day may keep the doctor away, but when that doesn’t work, at least your HSA can help keep the tax man at bay.