Do the Payroll Tax Benefits of an HSA Really Matter over the Long Haul?

Health Savings Accounts offer tax benefits that no other long-term account can match. But do those additional savings really matter over time?

Many Americans have a math phobia. When people start talking about numbers - tax rates, returns on investment, incomes, etc. - they quickly turn their attention elsewhere. Too bad. Often, people can leverage small changes in spending or investing to create results out of proportion to the simple adjustment.

Saving for retirement falls into this category. People who understand how Health Savings Accounts work and their tax advantages versus other retirement accounts can generate more spending power in retirement without diminishing their lifestyles today. That's a great way to craft a more secure financial future.

Let's explore how leveraging a Health Savings Account to increase your spending power in retirement.

Tax Treatment

Most Americans save for retirement through a tax-deferred 401(k) plan or similar workplace-based program. The lure is that contributions are excluded from taxable income. Thus, if you contribute $1,000, the full amount is deposited into your plan before income taxes are applied. You then pay income taxes on distributions, when the account has a higher balance but, at least in traditional thinking, marginal tax rates are lower (an assumption that may not hold true for future retirees).

Health Savings Accounts differ from 401(k) plans in their tax treatment in two distinct ways:

• Contributions aren't subject to federal payroll taxes (7.65% on the first $137,000 of income in 2022).
• Distributions aren't included in taxable income if the funds are used to reimburse qualified medical, dental, vision, over-the-counter, or premium expenses.

Does this tax treatment make a difference? Let's see.

Payroll Taxes

Most Americans incur payroll taxes of 7.65% on their income. Thus, if you earn $50,000 in 2022, you pay $3,825 in payroll taxes. There are no exemptions, no exclusions, and no deductions. This tax applies from the first dollar of income to the last.

What difference does this tax treatment make over time?

Imagine you save $3,000 for retirement in 2022 and increase that amount by $100 annually. (Note: This isn't a suggested level of retirement saving, but rather a figure with which we can work easily in this illustration.) If you deposit those funds into a Health Savings Account through pre-tax payroll deductions at work, you enjoy an immediate 7.65% return over the same amount contributed to a tax-deferred 401(k) plan. Over 30 years, at an average balance growth of 6% annually, that's nearly an additional $25,000 in your account.

That's right - you're $25,000 wealthier. You make the same sacrifice of annual consumption for 30 years and you earn the same amount whether the funds are invested in a Health Savings Account or a 401(k) plan. This one element of tax treatment increases your balance by nearly $25,000. If your annual qualified expenses in Year 31 are $12,000, you can cover almost two-and-a-half years' worth of premiums, cost-sharing, and non-covered services

Distributions

The other major tax difference between the two accounts is the tax treatment of withdrawals. All distributions from a tax-deferred retirement plan are included in taxable income. In contrast, Health Savings Account withdrawals for qualified expenses are always excluded from taxable income.

How do taxes affect the spending power of retirement savings? Let's supposed you face a 17% marginal tax rate in retirement. Today, that would be rates of 12% for federal income and 5% for state income taxes. If you live in a state with no income tax, your rate will be lower. Retire in the future, and your federal marginal tax rate may be somewhat higher or lower than 17%. For now, this is a realistic figure. The math isn't pretty, but it's simple enough not to choose a less realistic figure because the numbers are cleaner.

Continuing the example above, you spend $25,000 during the first two-plus years of retirement. How do you fund that $25,000?

If you withdraw the funds from your Health Savings Account, you must withdraw only $25,000 because the distribution isn't included in taxable income.

If you pay the same expenses from your tax-deferred 401(k) plan or IRA, you must withdraw $30,120 to pay your medical bills and the taxes ($5,120) on the withdrawal.

Effect on Retirement Savings

Average and median retirement-account balances vary by age. Older people have had more time to contribute, and their balances have had more time to grow. The relevant figure is the median balance, that is, the figure that's in the very middle of the balance distribution. In other words, if you have five neighbors who earn $50,000 per year and one who earns $750,000, the median is $50,000. (In contrast, the average, $200,000, which paints a much distorted picture of wealth on the street.)

The median balance for Americans age 55 to 64 is about $84,7000 (the average is about $232,400). Think about that. The example above, in which someone can save an additional $25,000 over 30 years by shifting contributions to a more tax-efficient account, would represent about 30% of typical senior's retirement savings. That's real money. And it's generated entirely from tax savings - not another dollar diverted from current entertainment, travel, college savings, or housing and utilities spending.

The Bottom Line

The example above is simple yet illustrative. Given our contribution pattern ($3,000 in Year 1, then adding $100 annually for a total of 30 years), you generate an additional $25,000 in "free" contributions. And when you spend those funds, they have the spending power of more than $30,000 from a tax-deferred account. And all because you contributed in a more tax-advantaged manner.

Yet like other financial benefits, the benefits flow to those who learn and understand how to leverage tax policy to maximize personal wealth. And now you know.

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