How to Help Clients Take Advantage of Tax Deductions With Their HSA

Christine Simone
June 7, 2022

As a comprehensive financial advisor, you know how important it is to be able to offer insight and planning recommendations on all aspects of your clients’ financial lives. This is especially true when it comes to their healthcare needs, but healthcare planning can be a complex and involved undertaking.

If you’re working with clients who have a Health Savings Account (HSA), educating them on how to take advantage of the available tax deductions is a great way to start the healthcare planning conversation. Below, we’ve included the most important information regarding HSA tax deductions your clients need to know. 

What Is a Health Savings Account? 

As a reminder, an HSA is a tax-advantaged medical savings account that your clients can contribute to and withdraw from tax-free for qualified medical expenses. 

Funds in an HSA are split into a liquid cash account and an investment account. Most HSAs allow contributions to be automatically invested once the cash account has reached a specified threshold. The investments also benefit from tax-free growth.

Your clients can only contribute to an HSA if they have a qualified high-deductible health plan (HDHP), so you’ll need to find out what type of health plan your clients have before advising them to use an HSA. Clients who are already enrolled in Medicare may not contribute to an HSA.

How Clients Can Make Contributions to Their HSA

There are a few different ways your clients can contribute to a health savings account. The way they contribute will have an effect on how they take advantage of the HSA tax deductions available to them. 

Employee Payroll Deduction 

If your clients have an employer-sponsored HDHP with an attached HSA, they can have their contributions deducted from their paycheck pre-tax.

Employer Contributions 

Your client's employer can also choose to contribute to their HSA. Any employer contributions are also tax-free, as they don’t count as part of your client’s annual gross income (AGI). Essentially, this is money your clients can earn without paying taxes when their employer contributes directly to their HSA. 

Direct Contributions

Alternatively, you can help your clients set up direct contributions to an HSA that are either recurring or made on a one-time basis. 

For example, many clients who are self-employed with a Marketplace HDHP will need to make contributions themselves. Those contributions will be deducted from their AGI when they file that year’s tax return. Likewise, clients with an employer-sponsored HDHP/HSA may want to make one-time contributions at the end of the year to max out their contribution limit. 

HSA Income Tax Deductions

It doesn’t matter whether your client contributes pre-tax money to their HSA through payroll or makes direct contributions. Either way, those contributions are income-tax-free. If they make direct contributions, they’ll benefit from a tax deduction that lowers their AGI at the end of the year even if they don’t itemize deductions.

However, when clients make direct contributions to their HSA with after-tax money, they’ll already have paid payroll tax or self-employment tax — which they won’t be able to recoup. (Payroll taxes include Social Security, Medicare, and unemployment insurance, while self-employment tax includes Social Security and Medicare taxes). 

Any contributions to an HSA from your client or your client’s employer will be reported on tax Form 8889 and filed with their Form 1040 or 1040NR. While some clients will have an accountant or CPA who can fill this form out for them, others may file their taxes on their own. You can help remind clients who have an HSA to include this form when they file their tax returns. 

By encouraging your clients to contribute to their HSAs — and max out those contributions when possible — they can lower their taxable income. Reducing their taxable income can allow your clients to pay less in taxes and keep more money in their pocket. 

Other Tax Benefits of an HSA

In addition to income tax deductions, HSAs offer two other tax benefits: tax-free growth and tax-free withdrawals for qualified medical expenses.

Tax-Free Growth

Interest and investment earnings on HSA contributions can grow tax-free. For this reason, many people choose to make contributions to their HSA and let that money grow for as long as possible. If your clients contribute and invest money into their HSA for years or decades, they have the potential to grow a sizeable account balance. This tactic can be especially helpful for your younger clients who are generally healthy and don’t engage with healthcare often. Rather than using their HSA to pay for the few medical events and expenses they do have, they pay out-of-pocket and allow their HSA to grow. Doing this lowers clients’ taxable income and allows them to withdraw the money at any time, as long as they document it.

An HSA can be a great tool to save for retirement. It’s another source of income your clients can use in their retirement for medical expenses or other needs. Since medical expenses can make up a significant amount of a person’s budget during retirement, an HSA is a great way to save for those expenses.

Plus, your clients can also use HSA funds however they want after they turn 65, but they’ll have to pay income taxes on funds withdrawn for non-medical expenses. You can help your clients come up with a smart plan for using the money that accumulates in their HSA when they reach their retirement years. 

Tax-Free Withdrawals for Qualified Medical Expenses

No matter their age, any money your clients withdraw from the HSA to use on qualified medical expenses is tax-free, meaning they won’t have to pay income taxes on those withdrawals. They can withdraw money for medical expenses at any time without penalty. 

The IRS does have strict rules on what is considered a qualifying medical expense. Some common qualified medical expenses include: 

  • Doctor’s visits and copays
  • Dentist's visits and copays
  • Prescribed and over-the-counter medications
  • Medical equipment and supplies
  • Acupuncture or chiropractor treatments
  • Menstrual products
  • Physical therapy

Some health-related expenses that are not considered qualifying expenses include vitamins, general toiletries, and elective cosmetic procedures.

Additionally, clients typically can’t use their HSA funds to pay for health insurance premiums. However, there are a few notable exceptions. Any clients who are on COBRA, are receiving state or federal unemployment benefits, have eligible long-term care insurance, or are enrolled in Medicare can pay for these premiums using HSA funds.

If your clients spend money from their HSA on ineligible expenses, they’ll have to report that money on their annual income tax return and pay taxes on it. And if they withdraw money for non-qualified expenses when they’re under 65, they'll have to pay a 20% penalty in addition to income taxes. 

How to Help Your Clients Take Advantage of HSA Tax Deductions

Health savings accounts allow your clients to contribute tax-deductible money to a savings account they can invest and use to pay for qualified medical expenses. As their financial advisor, you can help clients who are eligible to contribute to an HSA take advantage of these great tax deductions as well as the other tax benefits associated with an HSA.

Simply by opening the conversation, you gain an understanding of how your clients currently use their HSAs. If they’re missing out on one or more advantages, you can use this opportunity to educate them about their options and strategize the best ways for them to use their HSA based on their needs, goals, and priorities.

By incorporating more robust healthcare planning into your clients’ comprehensive financial plans, you help them better prepare for the future. At Caribou, we provide support to financial advisors who want to integrate healthcare planning into their comprehensive financial plans. Follow our blog to learn more about ways you can include healthcare planning in your suite of services.

Content in this material is for general information only and is not intended to provide specific advice or recommendations for any individual.

Download "From $40K in Annual Drug Costs to $4K: A Caribou Case Study"

Download Healthcare Planning 101: A Starter Guide for Financial Advisors

Download the Caribou Case Study “Over 75% Savings in Health Plan Premiums & an Avoided Crisis”