Why Young Lawyers Should Consider Using an HSA
Executive Summary
The Health Savings Account is an often overlooked part of an employers benefits but it is a powerful investing vehicle if used properly. For young and healthy lawyers, it features many useful and attractive benefits. First, it allows people to save specifically for future health care costs. Over a lifetime, an average American is expected to spend well over $300,000 in medical expenses. Even a large retirement account will have a significant amount go towards healthcare costs so why not set up an account to pay for these expenses separately. The HSA also offers a triple tax advantage that is only available to HSAs. This blog also offers 3 strategies to get the most out of an HSA such as spend the HSA on current medical expenses, save and invest it for future medical expenses, or use the HSA for tax-free distributions in the future.
What is a Health Savings Account (HSA)?
A Health Savings Account (HSA) is a financial account that offers practical long-term benefits to the people who utilize it. The HSA is a savings account for people to save for medical expenses over their life in a tax-advantaged manner. Typically, young and healthy professionals can benefit most from utilizing this account, but they are not the only ones who can benefit from it.
Qualifying for an HSA
While typically a part of an employer’s benefits package, the HSA can be opened with companies outside your employer and the healthcare provider.
To qualify to open an HSA, lawyers need to:
Be enrolled in a High Deductible Health Plan (HDHP)
Not be enrolled in Medicare
Not be claimed as a dependent on the current year’s tax return
For most law professionals, the HDHP is the main criteria to meet before opening an HSA. For single individuals, their health insurance must have a deductible at or above $1,400 and $2,800 for a family plan.
Typically an employer benefits brochure will identify an HDHP for lawyers when making their benefits decision. HDHP also results in lower monthly premiums when compared to other plans due to the higher deductible.
Built to pay for medical expenses
The HSAs purpose is to help Americans save and pay for high medical expenses. Medical expenses are an inevitable part of life. This account allows us to prepare to pay for future medical costs while allowing our other retirement and investment accounts to pay for our lifestyles in retirement.
How much do Americans pay for healthcare over their lifetime?
A 2004 study found that the average American will spend $316,000 in medical expenses over a lifetime. It also found that women will end up paying a third more over their lifetimes than males for healthcare costs. Most of this difference is related to women living longer.
Lawyers should note that this study was done nearly 20 years ago. Not only are people living longer than they were 20 years ago, but prices have increased as well.
But how much do lawyers pay on health care costs throughout their lives?
This study found that between the ages of 20-40, most Americans only spend about 12% of their lifetime medical expenses. Americans between the ages of 40-65 incur about 20-30% of their lifetime medical expenses. Finally, about 50-60% of lifetime medical expenses happen after 65.
Roughly 80% of expected lifetime medical expenses happen after 40, and over half of these costs are during retirement. For young lawyers, saving for these expenses now will benefit them in the future.
Advantages of the HSA
Portable and Investable
HSAs have two key components that are beneficial to young lawyers. First, HSAs are portable. Meaning that if you leave an employer to move to a new firm, the HSA goes with you. You do not owe your employer anything.
For lawyers at the beginning of their career, this feature is reassuring that contributions and investments will be around when lawyers need them later in life.
Second, HSA contributions are investable like contributions to a 401(k) or IRA. These investable contributions allow a lawyer’s HSA to grow from continued contributions plus the earnings and income from investments. A lifetime of investing in an HSA will hopefully lead to a health cost portfolio well beyond just the contributed amounts due to the power of compounding growth.
Tax advantages of an HSA
The HSA is the only investment account in the United States that benefits from a triple tax advantage. Initial contributions are with pre-tax dollars, once in the HSA invested contributions grow tax-deferred, and finally, withdrawals are tax-free if used for qualified medical expenses.
Because lawyers typically pay taxes in a high tax bracket due to their high initial salaries and high long-term earnings potential, saving money on taxes can provide substantial savings to many legal professionals.
Tax advantage for contributions
After opening an HSA, a lawyer can begin contributing to their HSA to save for their retirement.
For young lawyers, the annual contribution limit is $3,600. Lawyers over the age of 55 can contribute an additional $1,000 a year. For first-year lawyers who are just opening an HSA, be aware that contributing the entire contribution limit amount in the first year can result in some contributions not receiving the pre-tax treatment. But this taxable feature should not keep lawyers from contributing up to the limit in their first year. It’s just to point out that lawyers will not receive as great a tax benefit as they will in future years.
Another aspect of HSAs is that employers can provide an employer match to an HSA. Unlike a 401(k), an employer match counts towards the annual contribution limit. If an employer matches HSA contributions up to $1,000, then an employee can contribute $2,600 plus the $1,000 from the employer will max out the $3,600 annual contribution limit.
Lawyers with HSA employer matches should take advantage of these because employer matches do not count towards taxable income. Plus if the employer match is available, it is a part of your total income package through your employer. Not taking the match is effectively giving yourself a pay cut.
HSA contributions are pre-tax because lawyers can deduct the contribution amounts from their income taxes. Lawyers should know that California and New Jersey tax lawyers on their HSA contributions for their state taxes. Lawyers in these states will still receive tax savings on their federal taxes.
Tax deferral of income and earnings from investments
Once contributions are in the HSA, lawyers can invest them through the account’s provided investment options. Like a 401(k), HSA investment options limit investments to certain assets like mutual funds.
As the investments grow through the compounding of earnings and interest payments, the ending balance in the future may be substantially higher than just the balance would have been had the contributions not been invested.
Lawyers who understand they can invest their HSA’s will do much better than their peers. A 2021 survey found that only 9% of HSA holders invest their contributions. Only 9% is a staggering statistic because most of the future value of an HSA will likely come from investments.
Lawyers in New Hampshire and Tennessee should know that their states tax the interest and dividends received from investments in an HSA. Lawyers subject to these taxes will still save money in federal taxes.
Distributions are tax-free if used for medical expenses.
The purpose of the HSA is to pay for medical expenses for Americans in a tax-advantaged way. Therefore, when a lawyer has a qualified medical cost that the insurance company does not pay for, lawyers can withdraw the funds from their HSA to pay for the service or reimburse themselves for prior medical expenses.
These qualified withdrawals only apply to medical expenses incurred after opening an HSA.
For distributions from an HSA that are not a reimbursement or charge for a qualified medical expense, the distribution will be subject to income taxes and a 20% penalty. The penalty is significant, and lawyers should avoid them if possible.
Once a lawyer turns 65, becomes disabled, or dies, HSA distributions for non-qualified medical expenses are only subject to income taxes. There is no 20% penalty.
HSA strategies for young lawyers
The HSA is a powerful investment vehicle because of its tax advantages and portability. Even though it is only for medical expenses, the HSA provides more flexibility than most people realize. Here are a few strategies that young lawyers should know about when opening an HSA to maximize its value.
Use it to pay for current medical expenses.
The most obvious strategy for the HSA is to use it to pay for current medical expenses. Since HSA’s are for people with HDHPs, the high deductibles can be expensive for lawyers who have not met their deductible yet.
Lawyers can withdraw money from the HSA to pay for expenses that count towards the deductible or costs incurred after meeting the deductible but are not paid by insurance.
The HSA is a great way to pay for current medical expenses because the HSA distributions represent pre-tax income. For lawyers in a 24% tax bracket, this results in a 24% savings. An employer match also increases the savings a lawyer can use for medical expenses in a given year.
Save and invest HSA contributions.
As shown above, most of a lawyer’s expected lifetime medical expenses come in the latter part of their life. For lawyers who can afford to pay for their current medical expenses out of pocket, allowing the HSA contributions to stay invested and grow over a few decades can provide immense financial benefits when lawyers are more likely to incur expensive medical costs.
The HSA allows lawyers to have a dedicated retirement account solely for expected health costs. The HSA separates funds so lawyers can use retirement accounts like a 401(k) and IRA for lifestyle expenses. This segregation of retirement money can provide lawyers with added confidence to retire.
HSAs also no longer have a 20% penalty after someone reaches the age of 65. After that, distributions are subject to income taxes. An HSA after 65 is similar to a traditional 401(k) or IRA because the tax rate in retirement determines the taxes owed. So the HSA can be a second Traditional 401(k) or IRA but with the added benefit that the HSA is not subject to the required minimum distributions of these other retirement accounts after reaching the age of 65.
Save and invest for large tax-free distributions in the future.
Another HSA strategy is to take advantage of the tax-free reimbursement feature of an HSA. Even though a lawyer incurs a potential HSA qualified medical expense, lawyers do not have to reimburse themselves that year.
Over time, a lawyer may likely pay for many different qualified medical expenses out of pocket. If the lawyer keeps these receipts of medical expenses, they can reimburse themselves at a later point all at once. As long as the medical costs weren’t previously reimbursed by the HSA or deducted from a lawyer’s tax return as an itemized deduction, the expense is reimbursable at any point in the future.
Over 20 years, a lawyer contributes to their HSA and invests the contributions. After 20 years, the HSA has a balance of $100,000. The lawyer also pays $25,000 in HSA qualified medical expenses out of pocket and keeps the receipts for all the expenses. In the 20th year, the lawyer takes a $25,000 tax-free distribution from the HSA to reimburse themselves for the years of accumulated qualified medical expenses. After reimbursement, the lawyer will need to keep the receipts with their tax records to prove the distribution was for reimbursement of medical costs. The lawyer can choose how to spend the $25,000 withdrawal without restrictions.
This strategy takes advantage of the compounding of contributions to an HSA. A lawyer has the flexibility of a tax-free distribution if the lawyer needs the cash (assuming they have medical expenses to match the distribution amount). A future tax-free distribution is beneficial for lawyers who incur medical costs early in their career at a lower tax bracket but can later withdraw the money in a higher tax bracket.
The HSA is a great investment vehicle for young and healthy law professionals. Taking advantage of this account’s features early in a lawyer’s career can have significant financial benefits over a lifetime. Developing Financial implements strategies to maximize the value of an HSA for lawyers who would benefit from it. If you are interested in learning more about how an HSA can be used in your finances, schedule a free Meet & Confer right now!
Disclaimer: Nothing in this blog should be considered financial advice or recommendations. Your questions are unique to you and your own personal financial circumstances. You should consult with a financial professional before making a financial decision. See full blog disclaimer.