Health savings accounts (HSAs) have been available for more years than many may realize.
They seem to have come into the spotlight when estimated stats for health care costs in retirement began appearing. Couples retiring in 2019, according to Fidelity, can expect to spend $285,000 in health care and medical expenses throughout retirement, up from $280,000 in 2018.
But in reality, HSAs were authorized by the Medicare Prescription Drug Improvement and Modernization Act of 2003 and signed into law by President George W. Bush on December 8, 2003. HSAs entered the market in January 2004 and were originally developed to replace the medical savings account (MSA) system used primarily for self-employed individuals.
Begonya Klumb, head of HSA, Fidelity Health Care Group says, “There is no disguising the sense of urgency we hear from employers and individuals who say that rising health care costs are among their biggest financial concerns. In fact, one-in-four Americans say that health care is the most critical issue facing our country today.”
These accounts offer individuals a way to save money while managing their health care costs. They combine a high-deductible health plan (HDHP) with a tax-favored savings account. But account contributions are limited: Calendar year 2020 limitations were recently released. The annual limitation for an individual will be for self-only coverage under a high deductible health plan will be $3,550. For an individual with family coverage under a high deductible health plan is $7,100. These are increases of $50 and $100, respectively, from the 2019 contribution limits.
The appeal of these accounts is that in most states’ HSA participants have a triple-tax benefit. Unlike defined contribution retirement plans, which incur federal and state taxes, HSAs offer tax-free contributions, tax-free growth on balances and tax-free withdrawals for qualified health expenses, making them a powerful savings and investing tool to address both current and future health care expenses.
But there are a few exceptions at the state level to this triple-tax advantage that many people, including plan participants, do not seem to be aware of. California and New Jersey are the two states that do not offer tax-free contributions at the state level while all states are exempt from federal government taxes on HSA contributions.
As of the 2005 tax year, six states—Alabama, California, Maine, New Jersey, Pennsylvania and Wisconsin—did not exempt HSA dollars from state taxes. But currently, besides California and New Jersey, Alabama was the last outlier when it eliminated similar rules on January 1, 2018.
The Impact of State Taxation
Asked if state taxation in these two outliers’ states will change in the foreseeable future, J. Kevin A. McKechnie, executive director, HSA Council at American Bankers Association, says, “So far there has been no legislative movement from either state. To go tax free would cost these two states millions of dollars—and every year that they wait will cost them more because there are millions of more HSA owners all the time.”
“For California, this is the first week of the new gas tax. The idea that they’ll think about reducing taxes when they are taxing more necessary products, is unrealistic,” according to McKechnie. And New Jersey has the highest property taxes in the nation.
Answering the same question, McKechnie says, “The value proposition is you let people pay on a tax advantage basis for the things they are going to use anyway. It’s never changed. It’s been the same since HSAs were inaugurated yet people choose them when their employer chooses to offer them.”
Looking at Fidelity Investments customer data, Klumb says, “We do see that adoption of HSA-eligible health plans is slightly lower in New Jersey and California than we see nationally. But for those who are enrolling in an HSA-eligible plan, we see high HSA adoption rates: 93.2% (CA) and 94.4% (NJ). These are actually slightly higher than the national average of 92.8%. In addition, the average annual contributions by HSA owners in those two states is also higher than the national average.
Should people in these states that are offered eligible HSA plans still save in HSAs? McKechnie says, “There is no question that they should. The very rich won’t be impacted but lower income workers are still better off in an HSA plan than any alternative. If people of more modest means, which is most HSA owners, stop saving in HSAs, they will need to pay federal money to satisfy their deductibles and co-pays. That may be why California and New Jersey still aren’t acting. Because people with HSAs are still better off than all the other citizens. That could be one of the plausible reasons not to mirror what every other state has done.”
In April 2018, America’s Health Insurance Plans (AHIP) released an update to its annual survey showing that enrollment in HSAs/HDHPs totaled at least 21.8 million as of January 2017, reflecting a 9.2% increase since the previous year. This survey was based on responses from 52 insurance companies. For context, based on these and other survey results, more individuals are enrolled in HSAs/HDHPs than the entire Medicare Advantage program—Medicare offered by private companies approved by Medicare.
Forty-two health insurance providers reported enrollment to AHIP by state and U.S. territory for 15.6 million lives with HSA/HDHP coverage as of January 2017. States with the largest reported HSA/HDHP enrollment levels were Illinois (1,623,027), Texas (1,534,513), Minnesota (1,178,559), Ohio (1,008,177), and California (1,001,308). New Jersey had 223,926.
The double-edged sword is that, from an education perspective, participants may not be aware that they are being taxed by the state and not being taxed by the federal government.
Klumb says, “It goes back to one of the biggest challenges of the industry, which is education. We need to get people to really understand the advantages of high deductible plans paired with HSAs—the advantage of saving not only for managing current health care expenses but also to save for future health care expenses in two, three, five years or in retirement. We still see a lack of understanding of the basics of how the account works so it wouldn’t surprise me if there were no big difference in the behaviors. As we look across the state data, it looks like people would not even be aware of the state taxes.”McKechnie says, “Everyone knows the parameters of an HSA at this point. My question to the states is what are you hoping to gain from these taxes? If it’s just revenue, then they must hold the view that people are already saving enough for their retirement, people are saving enough for their Social Security, and those are two laughable premises on their own that are not true.”