How does HDHP affect taxes?

High deductible health plans (HDHPs) paired with health savings accounts (HSAs) have become increasingly popular options for health insurance. HDHPs typically have lower monthly premiums than traditional plans, but higher deductibles you must pay out of pocket before coverage kicks in.

HSAs offer unique tax benefits that allow you to set aside pre-tax or tax-deductible funds to pay for medical expenses. So how exactly does enrolling in an HDHP impact your taxes?

Tax Benefits of HSAs

The primary way an HDHP affects your taxes is through the associated HSA, which receives preferential tax treatment. The main tax benefits are:

• Tax-deductible contributions – You can claim your HSA contributions as an above-the-line deduction on your tax return, whether you itemize deductions or not. This reduces your overall taxable income.

• Tax-free growth – Interest, investment earnings, and gains in your HSA grow tax-free. You pay no taxes on the growth of your account balance.

• Tax-free distributions – Withdrawals from your HSA used to pay for qualified medical expenses are not taxed at the Federal level. The distributions reduce your taxable income.

Rules for Tax-Deductible HSA Contributions

To receive the tax benefits, you must follow some rules related to HSA contributions:

• You must have a qualified HDHP to contribute to an HSA.

• Annual contributions are limited to IRS maximums – $3,650 (self-only) or $7,300 (family) in 2023.

• You can make an extra $1,000 catch-up contribution if age 55 or older.

• Contributions should be made directly to your HSA custodian, not your HDHP insurer.

• You cannot also have a full health FSA or other disqualifying coverage.

• You cannot be enrolled in Medicare or claimed as a dependent.

Document your HSA contributions and keep receipts. You must report total contributions on IRS Form 8889 when you file taxes.

Other Tax Impacts of an HDHP

Beyond the HSA itself, an HDHP can affect your tax situation in other ways:

• Higher out-of-pocket costs – With an HDHP, you pay more medical expenses until meeting the deductible. However, you can deduct qualified medical expenses that exceed 7.5% of your adjusted gross income if you itemize.

• Lower premiums – The monthly premiums for HDHPs are usually lower than for traditional plans. This results in less taxable income if your premiums are paid through a cafeteria plan or pre-tax payroll deductions.

• Employer contributions – Some employers contribute to your HSA tax-free. Their contributions are not included in your gross income.

• Flexible spending account (FSA) ineligibility – You cannot contribute to a general purpose health FSA if you have an HSA, eliminating that pre-tax benefit.

• Medicare payroll taxes – HDHP enrollees may pay higher Medicare taxes due to lower pre-tax premium payroll deductions.

When evaluating an HDHP for tax benefits, be sure to consider both the impact of the HSA as well as these other factors on your overall tax situation. Consult a tax advisor if needed.

Tax Treatment of HSA Withdrawals

The way you use your HSA funds also affects your taxes:

• If withdrawals are for qualified medical expenses, they are not taxed at the Federal level. This includes deductibles, copays, prescriptions, dental care, vision expenses, and more.

• If withdrawals are used for non-medical expenses before age 65, they will be taxed as ordinary income and subject to a 20% penalty.

• After age 65, non-medical withdrawals are taxed as ordinary income but avoid the 20% penalty.

You are responsible for determining whether distributions were used for qualified medical expenses. Keep documentation such as receipts and Explanations of Benefits.

HSA Contribution Limits and Tax Deductions

Below are the HSA contribution limits for 2023 and the resulting maximum tax deductions:

Contributions can be made any time up until the tax filing deadline, which is typically April 15 of the following year.

Examples of HDHP Tax Benefits

Here are some examples of how an HDHP can generate tax savings:

Example 1

• Sara enrolls in a self-only HDHP with $3,000 deductible
• Her health insurance premiums are lower, reducing taxable income
• She contributes $3,850 pre-tax to her HSA
• The contributions are excluded from her taxable income

Overall tax benefit = Lower premiums + pre-tax contributions

Example 2

• Mark incurred $6,000 in medical bills with his HDHP
• $2,000 was reimbursed from his HSA tax-free
• He deducts the remaining $4,000 as qualified medical expenses

Overall tax benefit = $2,000 HSA distribution + $4,000 itemized deduction

Example 3

• Nina is over 55 and enrolled in a family HDHP
• She contributes $7,750 pre-tax to her HSA
• She makes a $1,000 catch-up contribution
• Total contributions = $8,750 pre-tax

Overall tax benefit = $8,750 pre-tax HSA contributions

The examples illustrate how HSAs allow you to pay healthcare expenses tax-free while also reducing your taxable income.

Reporting HSA Activity on Your Tax Return

You must report HSA activity on IRS Form 8889 when filing your annual tax return:

• Total annual contributions made to your HSA
• Distributions taken from your HSA
• Whether or not distributions were used for qualified medical expenses

Your HSA custodian will send you tax forms 1099-SA and 5498-SA detailing contributions, earnings, and withdrawals for the year. Use these forms when completing Form 8889. Failure to report accurately can result in IRS penalties.

HSA Tax Benefits After Retirement

The tax perks of HSAs extend into retirement:

• Balance continues growing tax-free after age 65.
• Can still use funds tax-free for Medicare premiums and expenses.
• No required minimum distributions like retirement accounts.
• Funds can be withdrawn anytime for any purpose, just taxed as ordinary income.

An HSA lets you pay current healthcare expenses pre-tax while also building retirement savings for future medical costs.

Conclusion

The unique tax treatment of HSAs – tax-deductible contributions, tax-free growth, and tax-free distributions – provides significant tax advantages now and into the future. Contributing to an HSA while enrolled in an HDHP results in a triple tax benefit.

However, you need to evaluate the overall tax impact of lower premiums, higher deductibles, and loss of other pre-tax benefits. Consult a tax advisor to determine if an HDHP and HSA align with your financial and tax situation. Take advantage of the tax benefits appropriately by following HSA rules and documenting qualified medical expenses.

Frequently Asked Questions (FAQs)

Below are some common questions about how HDHPs affect taxes:

How does an HDHP affect my income taxes?

An HDHP allows you to contribute pre-tax or tax-deductible funds to an associated HSA and receive tax-free distributions for medical expenses. This results in tax savings.

What is the maximum HSA contribution I can deduct?

For 2023, it is $3,850 for individual coverage or $7,750 for family coverage. There is also a $1,000 catch-up contribution if age 55 or older.

Do I need to itemize deductions to deduct HSA contributions?

No, HSA contributions are deducted above-the-line from your gross income, regardless of whether you itemize or not.

Can I deduct my HDHP deductible and other medical expenses?

Yes, medical expenses in excess of 7.5% of your AGI are deductible if you itemize. An HDHP’s higher deductible results in more potential itemized deductions.

What tax forms report HSA activity?

IRS Form 8889, Form 5498-SA, and Form 1099-SA are used to report HSA contributions, earnings, and distributions.

Are non-medical HSA withdrawals taxed and penalized?

If under age 65, non-medical withdrawals