Funding HSA from taxable - does it make sense?

[nyclon]

I’m picking this question up from another thread where it didnt get any responses. Does it make financial sense to contribute to a HSA for a young FIRE retiree? Assume they are using an ACA HSA-compatible plan.

In theory it looks like this - their only income is from interest and dividends in taxable. They have 30x saved up (plenty of money). Young family.

Contributions would have to come from the int/div + some sale of stock to cover withdrawal rate - which all incur 20-23.8% tax. Then the HSA contribution is made (which reduces their tax presumably by the 20-23.8% on the same amount).

Does the family choose a HSA compatible plan or a low premium “easy pricing” plan where their costs are more predictable? The latter would seem important for someone who’s “on a budget”. But ultimately the question is - is contributing to the HSA in this scenario tax efficient?

[deltaneutral83]

I'm not sure of all the specifics but you simply miss out on the FICA side of the deduction if you do it outside a w2 job. as far as "what plan to choose" that is predominantly a math issue. I haven't seen many PPO's come out ahead of HDHPs from the offerings of most of my friends/colleagues. I have seen a PPO come out ahead in certain situations however so you always have to run the numbers and look at coverages of each plan but even on that note the HDHP seems to have the same or more coverage from the 5-10 plans I've looked at over the years.

[sailaway]

If you are looking at 23.8% tax on dividends, the HSA isn't going to make much difference, as it is a tiny percentage of both income and wealth. It is just a piece of the calculations to decide which plan is best for you.

[Mike Scott]

Yes, if you have HSA eligible insurance, but it's probably not going to make a lot of difference. The biggest piece may be the untaxed qualified reimbursements or even better combining tax loss harvest in a taxable account to fund contributions to the HSA. Still, the fundamental choice for the insurance plan should come first.

[mhc]

Next year will be my first full year of retirement. I was doing some tax calculations this weekend. It looks like I will pay no federal taxes next year. It actually looks like I may get money back (negative effective tax rate). My income is dividends, interest, and W-2 from RSUs vesting. This is not enough to cover our expenses. I will also need to sell from taxable account.

I have a HDHP so I am planning on contributing to my HSA. I will also do backdoor Roths from the W-2 income.

I'm still trying to figure out the plan for next year. Should I do Roth conversions? Which tax lots to sell to use up 0% cap gains?

[grabiner]

I’m picking this question up from another thread where it didnt get any responses. Does it make financial sense to contribute to a HSA for a young FIRE retiree? Assume they are using an ACA HSA-compatible plan.

In theory it looks like this - their only income is from interest and dividends in taxable. They have 30x saved up (plenty of money). Young family.

Contributions would have to come from the int/div + some sale of stock to cover withdrawal rate - which all incur 20-23.8% tax. Then the HSA contribution is made (which reduces their tax presumably by the 20-23.8% on the same amount).

The interest and dividends are taxed regardless of what you do with them. If you aren't spending them, you might as well invest them in a tax-favored account if one is available (529 for children's college savings, IRA if you have some W-2 or self-employment income, HSA if you have an HDHP).

The sale of stock is not taxed at 15%-23.8%; only the capital gain is taxed. If you sell stock for twice the purchase price, the tax cost is 7.5%-11.9% of the sale amount.

And the HSA deduction is at your regular income tax rate. If you are paying 23.8% tax on your capital gains, then HSA contributions are deductible at 35% or 37%. If you are paying a more common 15% on your capital gains, then HSA contributions are deductible at a rate which is usually 22% or 24%.

[nyclon]

I’m picking this question up from another thread where it didnt get any responses. Does it make financial sense to contribute to a HSA for a young FIRE retiree? Assume they are using an ACA HSA-compatible plan.

In theory it looks like this - their only income is from interest and dividends in taxable. They have 30x saved up (plenty of money). Young family.

Contributions would have to come from the int/div + some sale of stock to cover withdrawal rate - which all incur 20-23.8% tax. Then the HSA contribution is made (which reduces their tax presumably by the 20-23.8% on the same amount).

The interest and dividends are taxed regardless of what you do with them. If you aren't spending them, you might as well invest them in a tax-favored account if one is available (529 for children's college savings, IRA if you have some W-2 or self-employment income, HSA if you have an HDHP).

The sale of stock is not taxed at 15%-23.8%; only the capital gain is taxed. If you sell stock for twice the purchase price, the tax cost is 7.5%-11.9% of the sale amount.

And the HSA deduction is at your regular income tax rate. If you are paying 23.8% tax on your capital gains, then HSA contributions are deductible at 35% or 37%. If you are paying a more common 15% on your capital gains, then HSA contributions are deductible at a rate which is usually 22% or 24%.

Thanks for the thoughts. In this scenario we can assume that the withdrawal rate requires sale of stock because the int/divs don’t cover all of the spend requirements.

There are no other income sources.

It sounds like the tax on the interest (taxed at ordinary income rates) may be enough for this to make sense since it’s likely that the cap gains rate will be 23.8%.

[nyclon]

Update here.

As earlier posters mentioned the HSA contribution and its tax benefits would be at the margins. I ran some numbers, and in this case, it looks to be worth the effort, and indeed at the margins- but as you’ll see no one knows for certain because we’re talking about insurance and hypotheticals. Here’s the hypothetical:

HDHP HSA Insurance plan annual premium: $15,000
2024 HSA contribution: $8,300

Marginal reduction in tax burden with HSA contribution: $3,000 (~36% of the HSA contribution)

Taxes paid on $8,300 contribution: $1,975 (23.8%)

There is a $1k tax savings in this situation, realized immediately. Going forward, all dividend and cap gains will be tax free.

The obvious potential offset is out of pocket costs associated with the HDHP plan that an “easy pricing” plan wouldn’t have - but it looks likely that the increased premium of the easy pricing plan would offset those costs. And, the max out of pocket for both plans puts them head to head in a catastrophic scenario.

All in all, the contribution seems to be well worth it in this hypothetical.

[tj]

If you have ACA plan options that are most cost efficient than the HSA one, it wouldn't make sense.

[nyclon]

If you have ACA plan options that are most cost efficient than the HSA one, it wouldn't make sense.

Agreed - but amount of usage could change the conclusion, which makes the analysis impossible to get right.

[peteyboy]

Update here.

As earlier posters mentioned the HSA contribution and its tax benefits would be at the margins. I ran some numbers, and in this case, it looks to be worth the effort, and indeed at the margins- but as you’ll see no one knows for certain because we’re talking about insurance and hypotheticals. Here’s the hypothetical:

HDHP HSA Insurance plan annual premium: $15,000
2024 HSA contribution: $8,300

Marginal reduction in tax burden with HSA contribution: $3,000 (~36% of the HSA contribution)

Taxes paid on $8,300 contribution: $1,975 (23.8%)

There is a $1k tax savings in this situation, realized immediately. Going forward, all dividend and cap gains will be tax free.

The obvious potential offset is out of pocket costs associated with the HDHP plan that an “easy pricing” plan wouldn’t have - but it looks likely that the increased premium of the easy pricing plan would offset those costs. And, the max out of pocket for both plans puts them head to head in a catastrophic scenario.

All in all, the contribution seems to be well worth it in this hypothetical.

Here is a scenario that would make obvious sense (and cents), at least to me.

1. Get HDHP for family.
2. Open HSA with $1.
3. Save all medical related recipes for that year.
4. The following year contribute the $ amount equal to the receipts of previous year.
5. After the contribution transfer is complete, withdraw that same amount.

Repeat steps 3-5 annually.

In essence, this makes medical expenses up to the HSA contribution limit tax deductible.