How to Lower your Taxes with an HSA

With tax season upon us, many people are looking for ways to decrease their taxes owed. If you have a qualifying High Deductible Health Plan (HDHP), you can use an HSA to reduce your tax liability for the year.

Tax Free Contributions

One of the main tax benefits of HSA’s is that money you contribute is tax exempt. You lower your taxable income by the amount of your HSA contribution. Thus, Health Savings Accounts can allow the total amount you in taxes in a given year.

The mechanics of this can work in two ways:

  1. Automatic HSA Contributions (paycheck) – If your HSA contributions occur via your employer, when your paycheck is processed your HSA allocation will be pre-tax. It is removed form your income, and you pay taxes on the remaining income.

    Thus, your taxable income = [Salary – HSA Contribution].
  2. Manual Contributions – If you contribute to your HSA manually (say, by bank transfer each month), you will have earned the income and already paid taxes on it. Never fear, you will make this up in your tax filing. When you file your taxes (using Form 8889), you will declare how much you contributed to your HSA that year. This will be deducted from your Taxable Income, so you will receive those original payroll taxes back as a refund.

    Again, your taxable income = [Salary – HSA Contirbution].

An Example of HSA Tax Savings

The maximum HSA contribution for 2014 is $3,300. Without an HSA, this $3,300 is earned and taxed as normal income. For example, if your tax rate is 25%, you pay $825 in taxes while the remaining $2,475 goes to your bank account. Federal and State taxes take a sizable amount of your earnings, and you keep 75%.

Using an HSA, you can divert this same $3,300 to a tax advantaged account so that you keep 100% of it. Instead of having money taxed and only $2,475 in your account, you have the whole $3,300. This is a tax savings of $825, or:

Tax Savings = HSA Contribution x Tax Rate

The best part is you own this money and get to keep it forever, unlike some flexible spending accounts. You can use your HSA to pay for many qualified medical expenses tax free. You can invest it and let it grow, and even use it for retirement without penalty (in this scenario, you would defer income taxes until retirement, likely paying taxes at a lower rate than currently). As you can see, you avoid (or defer) paying taxes, which keeps more money in your pocket to save and grow.