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Looking to Pay Less in Taxes? Consider a Health Savings Account

How you can transform spending on health care into a tax-savings strategy.

Tax Day 2012 is still a way off, but those with financial sense are making sure they contribute as much money as possible into their Individual Retirement Accounts for 2011.

What many don't realize is their health plans could very well contain a fabulous savings vehicle, called a Health Savings Account, which they also could be funneling money into.

An HSA allows participants to make tax-deductible contributions for the purpose of saving for out-of-pocket health-care expenses. If the money is used for eligible health-care expenses, withdrawals are also tax-free. If used for other purposes, there is a 20% penalty on funds withdrawn until age 65, but the account can be treated like an IRA after that age. Employers offer HSAs only in conjunction with a high-deductible health-care plan, mostly as a means of helping participants pay for their routine health-care expenses that aren't covered.

My entrepreneur clients often are astounded that they can take health-care spending, an often burdensome cost that may take money away from their businesses, and turn it into a vehicle for greater savings and financial freedom.

If you are lucky enough to have had a Health Savings Account-qualifying health plan this year, it may be advisable to try to put as much of your money into the account as you can. You still have until April 17, 2012, to make your maximum contribution for this year: That's $3,050 for singles or $6,150 for families.

Related: 75 Items You May Be Able to Deduct from Your Taxes

You don't have a plan with a Health Savings Account? You may be missing out on a strategy that can put you -- and not the insurance company -- in control of your health care. The HSAs/high-deductible plan pairing, because it often requires people to pay more for their routine health expenses, can help to motivate you to be healthy, shop for the best priced health care and prescriptions, and pay cash when possible for health-care services, receiving discounts in the process.

In my opinion, these little gems also may be the most underutilized tax-savings strategy in the U.S. Congress created HSAs in 2003. They combine tax deductible contributions, tax-free growth, and tax-free withdrawals for health care expenses.

In a nutshell, these accounts allow you to save funds pretax that you then use to pay for health costs. Because they’re paired with high-deductible health plans with lower premiums, the business is likely to save money right off the bat. One downside of choosing a high-deductible plan instead of traditional health insurance can be higher out-of-pocket expenses. This can be particularly onerous if you have or develop diabetes or another chronic health condition.

HSAs can also be a great savings vehicle. The money carries over year to year. You don't ever use the money? You can start withdrawing it without penalty for general retirement expenses after you turn 65.

Here's an example of how an HSA paired with a high-deductible plan can help people save money. A real-estate agent client of mine paid $900 a month for health insurance for his family (a typical low-deductible health-care plan). While this amount may seem high, the premium was actually below the national average of about $1,100 for family coverage, according to the Kaiser Family Foundation. They were a reasonably healthy family.

After learning about the HSA strategy, he secured a high-deductible family plan for approximately $400 per month. He took the $500 savings and deposited the money in an HSA. Although he and his wife were nervous facing a higher deductible, they quickly saw their savings adding up in their HSA. When they had to see a doctor, they had the funds in their HSA to pay for it. Because they didn’t use up the money in the HSA, the funds continued to grow tax-free.

Related: Five Rules for Writing Off Meals and Entertainment Costs

Here's a sampling of some of the benefits of HSAs:

  • You save on taxes. Not only are HSAs pretax accounts, but contributions to them are deductible from your gross pay amount on the front page of your tax return, potentially putting you in a lower tax bracket.
  • You can also spend the money tax-free. The caveat is that the money must be spent on qualifying health expenses. The great thing is that this tax-free rule on spending applies for the rest of your life. As long as you're using the money for health expenses (and odds good that are you'll have those when you're older), in your retirement years your HSA could essentially act like a Roth IRA, in that, like a Roth, withdrawals after retirement are not taxed.
  • HSA can help pay for your retirement. After you turn 65, there is also the option to withdraw the money for nonhealth-care expenses, and then pay federal income taxes on it. The HSA then acts much like a traditional IRA since the HSA holder pays ordinary income taxes on nonmedical-related withdrawals, with the added perk that you don't have the mandatory disbursements usually required by traditional IRAs.
  • An HSA can be an investment vehicle. HSAs allow you to invest the money in much the same way you invest an IRA. You can even invest HSA funds in real estate. So your health-care savings could also help you buy a rental property. It's generally advisable, though, to stick more with liquid investments if you have a health condition or are at risk of developing one; you want the money available in case of a medical emergency. These accounts survived the recent federal health-care reform changes -- the biggest overhaul of the health-care system since the 1960s, so it seems a safe bet that they'll be around – and available to save you money – for years to come.

Related: How to Survive a Tax Audit

The author is an Entrepreneur contributor. The opinions expressed are those of the writer.

Mark J. Kohler, a certified public accountant in Irvine, Calif., is a partner in the accounting firm Kohler & Eyre, and the law firm Kyler, Kohler, Ostermiller, & Sorensen LLP, specializing in business, estate and tax. He is the author of What Your CPA Isn't Telling You from Entrepreneur Press.

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