Can Your HSA Help Reduce the Taxes on Your Social Security Benefits? Yes!

We don't often think of medical reimbursement and Social Security benefits at the same time. But they're related. And we need to understand how.

This is the third installment in our four-part series on the four lesser known tax benefits of a Health Savings Account. The phrase "pre-tax contributions, tax-free growth, and tax-free distributions for qualified expenses" os oft repeated and should be set to music. But not everyone undrstands or appreciates that payroll taxes aren't applied to pre-tax payroll deductions, Health Savings Accounts aren't subject to Required Minimum Distributions, and withdrawals for qualified expenses don't trigger Medicare Part B and Part D premium surcharges (next week's topic).

Provisional income typically isn't a topic of polite conversations at the parties I attend with my almost-Medicare-eligible contemporaries. But it's an important concept to understand because it has implications for your retirement budget.

Taxation of Social Security Benefits

Prior to the 1980s, the federal government didn't tax Social Security benefits. Then in 1983, a bipartisan Congress (Democrats in control of the House and Republicans in the Senate) passed and President Reagan signed a Social Security reform bill that taxed half the Social Security benefit that wealthy retirees received. In the 1990s, another Congress and President Clinton added a law tthat included 85% of certain very high income Americans' Social Security benefits in their taxable income. Both efforts were part of broader bills to put the Social Security system on more solid financial footing.

Both changes to the law didn't include a provision indexing the thresholds to inflation. Over time, more and more Americans's Social Security benefits are taxed.

Provisional Income

The amount of a retiree's Social Security income that's taxed (0%, 50%, or 85%) depends on his provisional income. This figure includes the following income:

• Half of Social Security benefits,
• tax-deferred 401(k) and Individual Retirement Arrangement , or IRA, distributions,
• pension income,
• rental income,
• and income from tax-free municipal bonds.

The tax thresholds are:

• 0% income less than $25,000 (single filer), or $32,000 (joint filer).
• 50% income between $25,000 and $34,000, or between $32,000 and $44,000.
• 85% income greater than $34,000 or $44,000.

Here's a quick example for a single filer:

• $10,000 = half of his $20,000 Social Security benefit (the average in 2022).
• $ 5,000 = pension income
• $20,000 - IRA distributions, considting of $15,000 Required Minimum Distributions and an additional withdrawal of $5,000 to cover medical expenses.
• $35,000 provisional income = 85% of the $20,000 Social Security benefit is included in taxable income.

This taxpayer's taxable income is $42,000 (85% of the $20,000 Social Security benefit, or $17,000), plus the $20,000 IRA distribution and the $5,000 pension). The federal income tax liability is $4,848 (at the prevailing 12% marginal federal tax rate for that level of income).

Note that the calculation of provisional income uses only half the Social Security benefit, but actual taxes are applied on a percentage (0%, 50%, or 85%) of the total benefit.

The HSA Advantage

Let's look at another single filer with nearly the same income and expenses. The only difference is that this taxpayer funds the $5,000 of medical expenses from her Health Savings Account rather than her tax-deferred IRA. Her income looks like this:

• $10,000 = half of her $20,000 Social Security benefit (the average in 2022).
• $ 5,000 = pension income
• $15,000 - IRA distributions, considting of $15,000 Required Minimum Distributions and an additional withdrawal of $5,000 to cover medical expenses.
• $5,000 Health Savings Account withdrawal (not included in income calculation).
• $30,000 provisional income = 50% of the $20,000 Social Security benefit is included in taxable income.

This taxpayer's taxable income is $30,000 (50% of the $20,000 Social Security benefit, or $10,000, plus the $15,000 IRA distribution and the $5,000 pension). The federal income tax liability is $3,386.

That's a tax savings of $1,462. Yet both had the same Social Security income and same pension income, and withdraw the same amount from other accounts to cover $42,000 of expenses. But one difference - paying the medical expenses out of a Health Savings Account rather than the tax-deferred IRA - reduced the amount of her Social Security benefit taxed by $7,000 and kept the $5,000 Health Savings Account withdrawal out of her taxable income.

Imagine your retirement income is $42,000 and you have an extra $1,462 to spend on what's important to you - travel to a granddaughter's school play or graduation, auto repairs, a few days on a relaxing vacation. That additional spending power is yours not because you saved more for retirement, but rather because of your allocation of savings between a tax-deferred retirement account and a Health Savings Account.

This point bears repeating: With the same sacrifice in current consumption during their working years, these two retirees have identical Social Security benefits and identical withdrawals from savings accounts. But their allocation of their savings between accounts allows one of them to purchase an additional $1,462 of goods, services, and experiences. All because they understood the power of Health Savings Accounts and their effect on provisional income.

The Bottom Line

So, now you understand the difference in retirement income that yhou can enjoy from tax savings. You understand the role that a Health Savings Account can play in your retirement story. The financial ball is in your court.

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