Latest Edition of the Tax Newsletter
Hello Former 15.518ers,
Sorry for the delay in getting Edition 2 together. On Monday (Aug 4) I gave one of the main plenary talks at the annual American Accounting Association meetings so was tied up with getting that together (once the related paper is published, I will link it in a future edition for anyone who is interested).
Remember none of what I write is officially tax advice or investment advice.
Today I want to focus on Health Savings Accounts (HSA). If there is one thing I wish I would have done differently, it would have been to use an HSA sooner than I did. In class we covered various savings accounts, categorized by their tax treatment. The last one we covered was Savings Vehicle 7 (in the language of the textbook’s framework). The example of that type of account is a Health Savings Account. If you don’t remember, here is the chart we used:
Focusing in on the bottom row (in blue), you can see that when you invest in these accounts you get a tax deduction up front (operationalized generally by you telling your employer you want to contribute $X dollars to the account, the employer withholding the amount from your paycheck and depositing it into an HSA, and then the employer NOT including that amount as taxable wages when they report your W-2 to you and to the IRS). So, you are putting pre-tax dollars into the account.
You can use the funds in the account for qualified medical expenses at any age. IF you use the funds for medical expenses either while working or when retired, there is no taxation of the earnings or of the withdrawal of your original investment. Notice there is no ‘times (1-t)’ to get you to a net after-tax value at the end of the equation in that blue row. This is a great deal – deduction up front and no taxation later (if used for medical costs).
If you withdraw funds before you are 65 and use them for costs other than medical costs, then you will pay income tax and you will pay a 20% penalty. (So don’t do this!)
If you do not use the funds when you are working and you save the account until you are 65 or older, then you can withdraw the funds penalty-free to use just as you would your 401K savings. In other words, once you are 65 the account is treated like a defined contribution plan (Savings Vehicle 6 above) if you use the money for costs other than medical expenses. You will pay income tax on the withdrawals but no penalty.
There are rules and limits as you would expect with any tax treatment that a tax professor characterizes as a great deal. The limits and ages change often so always look them up every year if you are considering this type of account. For 2025 the:
- Contribution limit for an individual is $4,300 for an individual and $8,550 for a family.
- If you are 55 or older, you can contribute an extra $1,000 annually as a catch-up contribution. (Not as big of a deal as your 16th or 21st birthdays, but the day you reach the age to be eligible for catch-up contributions is a good day 😊…even if you don’t really need to catch up!).
- You can and should designate beneficiaries for the account.
- Often, your employer will contribute money to the account as well. For example, MIT puts in $1,000/year.
- You must have certain types of health care plans to be able to invest in an HSA.
On that last point, historically and most commonly for you (I think), is that you need to be enrolled in a high-deductible health care plan. This means you pay lower premiums but you will have to pay more if you need medical care. This always scared me when I was younger and when my kids were little. But it shouldn’t have. What is important is the ‘out-of-pocket’ maximum under the plan. If the out-of-pocket maximum is an amount you can afford to pay (in effect, self-insure up to that amount), then you should be in good shape to choose this type of plan. You have to decide for yourself, given your own facts and circumstances though, so check into your company’s plan in detail.
If you go with a HDHP, your premiums will be lower (for you and your employer, saving you both money which is why they usually are willing to contribute some to your HSA). You can use the savings from the lower premiums to invest in an HSA. Note that if medical costs arise, you can use funds from outside your HSA or you can use the HSA funds to pay the medical costs the HDHP does not cover. If you can pay the medical costs using money outside the HSA and leave the savings in the HSA, that account will grow tax free until you retire and, as discussed above, you can use it for medical expenses (with no tax) or use like a retirement account (and pay income tax just like with a traditional 401K). Basically, it is an additional way to save for retirement.
These accounts were expanded in the OBBB. You can read about the expansion here – it is basically allowing more people to be HSA eligible. The House version of the bill allowed even more expansion and a higher contribution amount, but that was pared back in the Senate (you can read about what almost was, here).
A final important point about these accounts, is that the money needs to be managed once it is in the account. The accounts are gaining in popularity (some stats here), but it turns out, that some people do not invest the money but leave it in cash not earning much of a return. That is not the optimal strategy. If you will definitely need the money for medical costs in this year or next year then cash might be right. However, any portion of the account you are saving for your retirement years, should be invested in something that earns a return (preferably a high return!). Here is an article about that and one from Fidelity explaining how to set a cash target for your HSA.
I hope this is helpful to you! I will come back to the OBBB next edition.
I have been adding more years of 15.518 to the distribution list. If you were not on the list for Edition 1, you can find that here. Also, I want to thank you all for the kind words about the class and how you have used the information since leaving Sloan. It was great to hear - I appreciate it!
Thanks,
Michelle