Over the next several months, many small employers will face inevitable group health care insurance premium increases on their 2016 plan renewals as the safety net associated with grandmothered Affordable Care Act (ACA) plans expires in certain states. A new premium pricing structure will be imposed on small groups due to underwriting requirements included in the ACA.
This new pricing formula will force many small business owners to look for new ways to reduce the cost of providing healthcare benefits to their employees. Couple skyrocketing group health insurance premiums with the negative sentiments that many small business owners have about paying high taxes, and you have a recipe for frustration on Main Street USA. Or, maybe it’s an opportunity to lighten your small business tax burden.
The High Deductible Health Plan Alternative
According to the Employer Health Benefits Annual Survey conducted by Kaiser/HRET, in 2013, 20% of group-sponsored health insurance plans were High Deductible Health Plans (HDHP), with the trend toward using such plans growing steadily. Let’s explore what an HDHP plan is, why it’s growing in popularity and why every small business owner should consider embracing the tax advantages that its powerful sidekick, the Health Savings Account (HSA), has to offer.
Reduced Premiums for the HDHP
HDHPs provide a way to cut employee benefit costs due to their lower premiums. And while it’s believed that lower premiums for HDHPs are the basis for their recent rise in popularity, such savings don’t come without a catch. But using a different type of group health insurance plan won’t by itself reduce the total cost of healthcare for employers and employees.
When using an HDHP, a portion of the total cost for providing healthcare shifts from the plan sponsor (the employer) to the subscriber (the employee). Essentially, HDHPs compel the subscriber to cover a greater amount of the cost of healthcare by requiring a higher deductible and a greater level of out-of-pocket expenses.
On its face, the individual employee does not benefit from such a plan. If coupled with an HSA plan, however, the HDHP becomes a powerful healthcare cost and tax-saving strategy for everyone. And it likely explains why HDHPs have grown in popularity recently, and why they are expected to continue to be adopted by many more small group employers in the future.
Set up a Health Savings Account
To take full advantage of this cost and tax-saving strategy, the small business employer enrolls employees in an HDHP and deposits money every payday for each employee into their individual HSA. The HSA is similar to an IRA: the amount of money going into the employee’s HSA is not subject to federal income tax or any other payroll taxes, such as Social Security or FICA, Medicare, unemployment, etc. And like other health insurance benefits paid by the employer, contributions to an employee’s HSA account are tax deductible on the business’ tax return for the year in which the contributions are made.
The HSA belongs to the individual, not the business. Its unused balance goes with the employee when he or she leaves the company to work elsewhere or retires. The amounts added to the HSA each year may be invested for future growth and income, which is tax-free during the years held.
Health Savings Account Tax Triple Play
Up to this point, the HDHP and the HSA combo appears to be very similar to an IRA or 401K in that contributions are tax deductible and income and growth is not taxed until used. But that’s not the end of the story.
The HSA is the only tax deferral strategy that can turn taxable income into tax-free income. But first, you need to understand the rules, then execute properly.
We’ve already discussed two ways HSAs escape taxation. First, the HSA deposits (from an employer or individual) are federal income tax-free and not subject to employment taxes. Second, HSA growth from income and investment appreciation is not subject to federal income taxes.
Now here’s where the HSA becomes the powerful triple play tool for long-term tax savings.
If the HSA funds are withdrawn for qualified medical expenses by the account owner, a spouse and/or dependents, such withdrawals are not subject to federal income tax. And there you have it. It’s a tax triple play. There is no other place in the tax code which allows ordinary income to escape federal taxation forever.
But of course, you have to know the rules and follow them carefully.
HSA Rules: The Devil is in the Details
Knowing the rules for how HSAs escape federal income tax is essential for small business owners and employees alike.
For example, if you have enough cash to supplement an HSA account over and above your employer’s contribution—and up to the maximum permitted by the IRS each year—you could build up a healthy nest egg for medical expenses incurred during retirement.
How? Don’t use the HSA during your high income years of employment. Instead, pay for qualified medical expenses (e.g., deductibles, co-pays, prescriptions, etc.) with funds that have already been taxed, and keep the HSA growing income tax-free for as long as possible. Remember, just like an IRA, income and growth escapes taxation when held within the HSA.
This strategy works well for a small business owner who faces high personal income taxes each year. At the current highest marginal rate of 39.6%, maximizing the HSA contribution—currently at $6,650 in 2015 for a Family HSA—simply makes good sense. While the small business owner (or employee) is in the highest federal income tax bracket, deferring the use of the pre-tax funds will be more efficient if he or she waits to use the funds during retirement when, at least in theory, his or her federal tax rate should be lower.
And if you’re over 55 and not receiving Medicare benefits, tack on another $1,000 to your annual HSA contribution. In all cases, contributions for any tax year must be made before April 15th of the following year in order to be deductible.
Another powerful attribute of the HSA is the lack of a required minimum distribution. While IRAs, 401Ks and other similar plans require a minimum distribution at age 70 ½, the HSA has no such requirement. This offers flexibility to the HSA owner during retirement years. He or she can access funds for qualified medical expenses without triggering federal income tax.
HSA owners should be prepared to prove that expenditures from their HSA were used to pay for qualified medical expenses by keeping expense receipts in case they are audited. Otherwise, a non-qualified medical expense paid from an HSA account is subject to federal income tax during the year of withdrawal. If the owner is under age 65, the distribution is also subject to a 20% penalty.
There’s one last tax planning detail worth noting. If someone is in a situation where they know their income tax rate will drop precipitously in the future, then withdrawing money from an HSA after reaching age 65 for a purpose other than paying a qualified medical expense may make sense, even though it will require the payment of federal income tax on the HSA withdrawal. If the federal income tax rate is lower when the withdrawal is made, then the taxpayer’s overall federal income tax burden on such a non-qualified expenditure would be reduced. Even if federal taxes must be paid when the withdrawal is made, the use of an HSA to defer income taxes while contributions are growing tax-free ultimately results in lower taxes. Not so bad.
For small business owners and their employees the combination of a High Deductible Health Plan and a fully-funded Health Savings Account has never been more attractive than it is right now.
To learn more about the Affordable Care Act, see our answers to frequently asked questions about healthcare reform.