An HSA Can Save Thousands in Taxes When You Need Tax Savings Most
Your Social Security benefit will be taxed - if you're lucky. But you have some control over how much of a bite federal income taxes take from your retirement income.
It didn't used to be this way. Prior to 1983, Social Security benefits weren't taxed at the federal level. Then, legislation shoring up the system's finances included a provision that included 50% of certain enrollees' benefits in taxable income. The income threshold - $25,000 for individual tax filers and $32,000 for married filing jointly - affected only a small percentage of high-income retirees.
During a subsequent reform in the 1990s, Congress added a new tier that adds 85% of benefits to taxable income above $34,000 (individual) and $44,000 (joint). Again, this provision affected only the highest-income retirees.
But those thresholds aren't adjusted for inflation, as most figures in the tax code are. Today, more than half of all Social Security recipients pay income taxes on at least a portion of their benefits. And the number will continue to increase - particularly in light of today's generationally-high inflation rate.
Provisional Income
The percent of your Social Security benefit that is taxed is a function of provisional income. To determine your provisional income, you sum the following:
- Earned income (wages from a part-time job).
- Income from pensions.
- Distributions from tax-deferred accounts (e.g., a 401(k) plan or Individual Retirement Arrangement)
- Interest (including interest on tax-free government bonds).
- Half your Social Security benefit.
If your provisional income is less than $25,000 (single filer) or $32,000 (joint filer) you pay no income taxes on your Social Security benefits. If your income falls between $25,001 and $34,000 (single) or between $32,001 and $44,000 (joint), half your Social Security benefit is included in your taxable income. If your income exceeds $34,000 (single) or $44,000 (joint), you include 85% of your Social Security benefit in your calculation of taxable income.
Example: You're single. You have $6,000 in earned income. You receive $20,000 in Social Security benefits (the average benefit in 2022). You earn $1,000 in municipal-bond income and withdraw $30,000 from a tax-deferred IRA. Your provisional income is $41,000 [($20,000/2) + $1,000 + $30,000].
In your case, 85% of your $20,000 Social Security benefit (a total of $17,000) is included in taxable income.
The Health Savings Account Advantage
How can you reduce that figure? Once you retire, your options are limited. You can reduce your distributions from your tax-deferred account (unless you're forced to withdraw a certain amount - $30,000 in our example above - because of government-forced Required Minimum Distributions, or RMDs). You'd have to reduce distribution by at least $7,001 to bring your provisional income below $34,000, which would mean that only 50% of your Social Security income ($10,000, rather than $17,000) is included in your taxable income. Your choices are to defer some bills until next year (a temporary solution) or reducing your spending by $7,001 permanently. Neither strategy is sustainable. And the latter becomes more difficult as your cost of living increases but the $34,000 threshold doesn't adjust upward.
Let's look at a different approach.
Example: Same income as above. You incur $7,200 in medical expenses, including Part B and Part D premiums ($2,640), one inpatient deductible ($1,556), 20% coinsurance on some outpatient services, a dental implant and crown, and some out-of-pocket costs for prescription drugs. This figure may seem high, but it's a pretty good extrapolation of Fidelity's survey showing that an average couple retiring at age 65 in 2021 will spend $300,000 on medical care in retirement. Given lifespans of about 20 years, that's approximately $7,500 annually ($15,000/20 years).
If you planned during your working years and funded a Health Savings Account to reimburse qualified medical expenses in retirement, you have another option. You can reimburse your $7,200 of qualified expenses from a Health Savings Account rather than a tax-deferred retirement account.
What's the difference? Health Savings Account distributions for qualified expenses aren't included in provisional income. That means your provisional income drops by $7,200, to $33,800. That figure is below the provisional-income level at which 85% ($17,000) of your Social Security benefits are taxed. Instead, only 50% of your benefit ($10,000) is taxed.
That's a tax savings of $840 (the $7,000 difference multiplied by the 12% marginal tax rate).
As an added bonus, the difference between withdrawing $7,200 from your IRA (included in taxable income) and your Health Savings Account (not included in taxable income) is tax savings of $864 ($7,200 multiplied by 12%).
Total tax savings: $1,704.
You achieve the $1,704 in tax savings without a reduction in retirement income. Because you focused during your working years on reducing taxes in the distribution phase of your retirement planning, you save $1,704 in taxes. All you had to do was reallocate a portion of your retirement savings from a tax-deferred employer-sponsored or individual retirement account to a Health Savings Account.
Other Benefits to This Strategy
Every dollar reallocated also escaped payroll taxes, which for most workers generates an immediate 7.65% increase in the amount contributed. That can make a huge difference over time, as you can increase your retirement nest-egg without any additional sacrifice of current consumption during your working years.
Also, Health Savings Accounts aren't subject to Required Minimum Distributions, as tax-deferred retirement accounts are. The federal government tells you, beginning in the year that you turn age 72, the minimum that you must withdraw from your tax-deferred account each year - a figure based on your expected lifespan and account balance. You must withdraw at least that much each year, even if you don't need that much . . . even if it pushes you into a higher marginal tax bracket . . . even if it results in your being taxed on 85% rather than 50% of your Social Security income.
Finally, Health Savings Accounts distributions for qualified expenses aren't included in the Income-Related Monthly Adjustment Amount, or IRMAA. This is a separate calculation that determines whether you pay an additional monthly premium for Medicare Part B (outpatient services) coverage beyond the $170.10 standard premium and the Medicare Part D (prescription-drug coverage) premium, which varies. The first incremental jump raises premiums more than $960 annually.
The Bottom Line
If you want to maximize your spending power in retirement, a Health Savings Account can play an important role. The fact that withdrawals aren't included in taxable income or the calculations of provisional income and IRMAA means that you can but more in retirement with the same sacrifice of current consumption during your working years.
The federal tax code can be confusing and sometimes appears to be downright illogical. But those who understand it can benefit. And those who understand the power of Health Savings Accounts and plan and act accordingly can reap the financial benefits during their retirement.
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2yAh, the power of Health Savings Accounts. Who knew?