"No Taxes on Contributions." But What about Those Federal Payroll Taxes?

The tax treatment of contributions to tax-deferred retirement accounts and Health Savings Accounts sound identical - until you read the fine print.

You've heard the catchy description of Health Savings Accounts: They're triple-tax-free: Contributions are pre-tax or tax-deductible, account growth is tax-deferred, and withdrawals for qualified expenses are tax-free. They're the only account to which most Americans have access in which neither contributions nor distributions are included in taxable income.

In this popular description, Health Savings Accounts combine the best features of tax-deferred retirement accounts (pre-tax contributions, though taxes on withdrawals) and Roth retirement accounts (taxable contributions, but tax-free qualified withdrawals). The concept illustrates the general principle of triple-tax-free.

But this description sells Health Savings Accounts short. They enjoy an additional advantage over both tax-deferred and Roth retirement accounts.

Taxation of Tax-deferred Account Contributions

Contributions to tax-deferred retirement accounts are free of federal and state income taxes. This treatment allows savers to delay the effect of taxes on their contributions by deferring their income-tax liability for decades. For a typical taxpayer facing a 22% marginal federal income tax rate and a 5% state levy, deferring income taxes means that every contribution of $100 into a tax-deferred retirement account reduces take-home pay by only $73 (the other $27 represents tax savings).

For working families with children who own a house, are saving for college, and want to give their kids the experiences of vacations, sports, Scouts, and other activities, this tax treatment is a godsend. Their retirement savings don't offset discretionary income dollar-for-dollar, which means that they can fund their retirement without feeling the full effect in their current take-home pay.

Let's illustrate this concept in simple terms. You have a choice of contributing $1,000 annually for 30 years into a tax-deferred retirement account or a taxable account. Your total income contributed to the tax-deferred account is $30,000. Your contribution to the taxable account is only $29,900 because the balance of your $30,000 sacrifice in current consumption went to pay federal and state income taxes. Increase your sacrifice of current consumption to $3,000 ($90,000 versus $65,700 deposited over 30 years) and the difference in balances is $30,700 after 20 years and nearly $66,000 after 30 years.

That's a huge difference over time with compound earnings. Clearly a tax-deferred account delivers higher balances than accounts funded with after-tax dollars.

But wait. Tax-deferred refers to income tax only. The federal government imposes a 7.65% payroll tax on the first $147,000 of income (and then 1.45% thereafter). The example above comparing contributions to tax-deferred account and taxable accounts is accurate in relative terms. Savers must pay payroll taxes on each dollar contributed, however. And that's a key difference between these accounts and Health Savings Accounts.

Taxation of Health Savings Account Contributions

The income-tax consequences of contributing to a Health Savings Account are identical to the tax-deferred account described above, with two glaring exceptions. Taxpayers in California and New Jersey must pay income taxes on contributions to their Health Savings Accounts. All other states either have no state income tax or allow a full deduction for Health Savings Account contributions.

But more important, and relevant in all 50 states, employees who fund their Health Savings Accounts through pre-tax payroll deductions through their company's Cafeteria Plan don't pay the federal payroll tax. Thus, they receive an automatic return (7.65% for most) on their money. That $1,000 annual contribution is deposited in full into their account. In contrast, owners of a tax-deferred account who makes the same sacrifice of current consumption deposit only $923.50 into their tax-deferred account.

That $76.50 difference may not seem like much. But imagine forgoing $1,000 annually in current consumption to fund a long-term account, earning a 6% annual return. If you deposited those funds in a Health Savings Account through a Cafeteria Plan (no payroll taxes), you'd have $2,900 more after 20 years and $6,200 more after 30 years by placing $1,000 in a Health Savings Account rather than $932.50 ($1,000 less the 7.65% payroll tax) in a tax-deferred retirement plan.

Again, those figures may not be compelling. But reduce current consumption by $3,000 annually and the difference grows to $8,700 after 20 years and $18,700 after 30 years.

The Effect in Retirement

We can't project how big an effect placing the deposits in the account with less tax friction will be worth in retirement. The most recent figures (2018) show that the average Medicare enrollee spent about $5,600 annually for medical coverage (Medicare premiums) and care (deductibles, coinsurance, copays, and basic services not covered by Medicare. If that figure triples during the next 30 years, the tax savings from diverting $3,000 of annual retirement savings from a tax-deferred account to a Health Savings Account (and not spending the funds prior to retirement) would still buy a full year of average out-of-pocket costs.

The difference may not rock your world. But it's real money. And you don't need to increase your retirement savings rate or your investment risk to achieve that difference. It's the result of tax savings that one account, but not the other, offers.

The Bottom Line

Health Savings Accounts weren't designed specifically to supplement retirement savings. But several key features of the accounts - you can accumulate balances over time and you can always reimburse qualified expenses tax free, even when you're no longer eligible to fund a Health Savings Account - makes it an ideal, painless way to increase your spending power in retirement.

Author's note: We never know when a new acquaintance will have a profound effect on our professional life. This column started four years ago this week. Special thanks to marketers extraordinaire Barbara Pfeiffer, who introduced me to the LinkedIn functionality to publish articles, and Lindsay Jacobs, who suggested during an industry conference in La Jolla, Calif., that I should write a weekly column to share my knowledge with the world. Thank you, both! 

HSAWednesdayWisdom #HSAMondayMythbuster #TaxPerfect #HSA #HealthSavingsAccount #yourHealthSavingsAcademy #yourHSAcademy