When you’re an attorney by day and a finance nerd by night, sometimes you have a unique sense of what “friendly conversation” means. When you have a tax attorney friend, it gets worse.
Well, I do have a tax attorney friend. Let’s call her “Ralphie,” in honor of the little boy lead in the holiday classic A Christmas Story. You see, when Ralphie spoke his mind at the dinner table, his family had a very specific reaction:
Where there’s tax, there’s room for disagreement.
Ralphie wondered why I wouldn’t take advantage of that glorious untaxed income today. She posited that HSAs were a godsend for the small medical expenses that we all encounter, especially as deductibles continue their eternal rise.
My alternative position: Ralphie was only kinda sorta right.
If you’re living paycheck to paycheck, a health savings account is a simple way to get a discount on your medical care immediately. But, to get the greatest benefit from an HSA, I figured, you should make an effort to bend over backward to pay for health care with after-tax money. Leave your HSA untapped, like that keg in the back that you might be able to return if you have fewer friends than you thought.1
How do you get the most benefit from your Health Savings Account?
As we already know, HSAs act pretty much as a traditional IRA with a little exception carved in for penalty-and-income-tax-free withdrawals for health care expenses. Basically, you contribute some of your pre-tax income to the account, invest it, and you can withdraw it any time for a health expense. You can also withdraw it at any time for any reason, but you will pay income tax if it is a non-medical purpose, plus a 10% penalty if you are under age 65.
If you are living paycheck-to-paycheck and are unable to fill every pre-tax investment available to you, there is no reason to not use your HSA for immediate expenses. You save some tax that year and you might see some small, tax-free gains on the money in the meantime. Alternatively, if that same money had gone into a different pre-tax investment, you’d need to pay a penalty to use it. Or, if you were to leave the money in the HSA but forgo saving in some other available pre-tax account, you’d need to use after-tax money for health care expenses that you otherwise would have paid for with tax-free HSA money, basically wasting the tax benefit available to you today.
But that advice doesn’t work for all of us. If you are already maxing all pre-tax accounts and still have sufficient take-home pay to cover your immediate medical needs, the scenario needs revision: You’ll be paying tax on the extra, post-maxing money anyway, so you might as well preserve your health savings account for future medical needs. Otherwise, you’d use the HSA money now, forgo the capital gains benefits it can provide, and invest your extra take-home pay in a taxable investment account. Here are the two (overly simplified) scenarios side-by-side for illustration:
Health Savings Account vs. Taxable Investment: A 30 Year Lesson
|Earned Income||$3,400.00||Earned Income||$3,400.00|
|Income Tax, Year 1||$0.00||Income Tax, Year 1||$850.00|
|Initial Contribution||$3,400.00||Initial Contribution||$2,550.00|
|Value, Year 30||$59,327.97||Value, Year 30||$44,495.98|
|Capital Gains Paid on Withdrawal, Year 30||$0.00||Capital Gains Paid on Withdrawal, Year 30||$6,291.90|
|Income Tax Paid on Withdrawal, Year 30 (without medical purpose)||$14,831.99||Income Tax Paid on Withdrawal, Year 30||$0.00|
|Income Tax Paid on Withdrawal, Year 30 (with medical purpose)||$0.00|
|Total You Get To Spend (without medical purpose)||$44,495.98||Total You Get To Spend||$38,204.08|
|Total You Get To Spend (with medical purpose)||$59,327.97|
In reality, the difference is very likely to be even greater for most of us. Your marginal tax rate is likely much higher pre-retirement than it will be in retirement – particularly if you earn so much that you are able to max out all pre-tax accounts and still cover your expenses. If your income is low enough in retirement, you may avoid capital gains tax even in a taxable account; but this change reduces the disparity by less than a change to your marginal rate for most of us.2
Bottom line: If you can afford to pay for your medical care with after-tax dollars and leave your money in the health savings account, you should. You’re taking advantage of a wonderful gift from the IRS: investment gains that may be free of income tax and capital gains tax, not matter how much income you earn!3
Is Ralphie a bad attorney?
In case she reads this, I should assure you: My friend is a wonderful tax attorney who has many a satisfied client. But her gut reaction relied on the typical, usually true advice: HSAs are great tools for immediate tax savings to help average people meet their high deductibles. For a person living paycheck to paycheck, this is likely the best advice.
But when you’re atypical, the typical advice may not apply to you. She hadn’t considered – until we discussed it – the idea that someone may not be living paycheck to paycheck. She hadn’t considered that, if you can afford to leave the money there, you get the best savings from your HSA by using it to keep Uncle Sam’s grubby hands off your long-term capital gains!
There’s a bigger picture developing here…
One mark of a good attorney is that, when confronted with an unusual situation, the attorney can adapt the typical advice. And that is precisely what Ralphie did.
Financial independence is an unusual goal for unusual people. If you seek the advice of a professional of any kind, such as that of a tax attorney, you must be very explicit about your plans to FIRE and what that means about your spending habits. Your professional will likely be smart enough to grasp the concept and hopefully its effects on the “typical” advice, like my tax attorney friend did. Or like I did when I drafted my own prenuptial agreement. But any professional – myself included – is unlikely to assume right out of the gate that you are spending less than you earn, that you’re thinking of tax consequences 10-30 years down the road, and that you plan to retire before your grandkids have kids. Because let’s face it: You’re a bit of a freak.
It is your responsibility, as the consumer of professional advice, to give that professional as much information to work with as possible.4 To expect them to assume that FIRE-specific advice is applicable to you is a bit like strolling into the nearest neighborhood family-run mechanic’s shop and assuming they have parts lying around for your 1981 DeLorean DMC-12. You know you’ll need to give the mechanic some time to find the parts; you’ll also need to give your professional all the information you can, and a bit of time to digest it.
Pick your professionals wisely, and let them know you’re weird!
- I was never popular.
- Your capital gains rate is likely to be either 0% or 15%, and that is a tax purely on the amount your investment grew. Your marginal tax rate, for the more lean-FIRE among us, is likely to be reduced to either 0% or 10% from a likely 25% or higher if you have high enough income to manage this strategy, and that difference is on all of the asset rather than just the growth on it.
- And, sometimes, FICA!
- And their responsibility to seek it!