Why Your State Might Be Sabotaging Your Retirement Strategy

The Heath Savings Account Revolution is in full swing.  Consumers are starting to adopt these plans at a greater rate than ever before.  In fact, Alegeus, the leading provider of HSA healthcare funding platforms found that HSAs are expected to overtake Flex Spending Accounts (FSAs) as the most common health benefit account by the end of 2019 with $44.3 billion in these accounts.

While the congressional intent behind HSAs was to lower health care costs for Americans, they have become the on-point retirement plan for Gen X, Millennial and Gen Z.  The ability to put money away and receive a tax deduction, have the money grow tax deferred and pay out tax free for qualified medical expenses is a clear home run.

“Currently, Millennials and Generation Xers make up nearly half of the people enrolled in HSA-qualified health plans,” says Steve Auerbach, CEO of Alegeus. “As HSA adoption increases, the investment opportunity will become more obvious as a winning strategy to save for healthcare in retirement.”

That is unless you live in California and New Jersey.  Forty-eight states agree that the HSA is a powerful tool and are piggybacking on the federal rules.  But California and New Jersey do not comply with the federal rules.  As a result, for taxpayers in those states, using HSAs is a bit more complicated and ultimately could sabotage even the best laid retirement plans.

Tax, Tax and More Tax

The power of the HSA stems from its triple tax benefits. In the Fidelity Retiree Health Care Cost Estimate, the average couple age 65 in 2019 may need $285,000 in after tax dollars to cover their medical expenses.  For those funding HSAs in their 20s, 30s and 40s, HSA dollars compounding over decades can make the difference in an individual having enough to retire comfortably or facing financial fragility in retirement.

But neither California nor New Jersey give their residents the ability to enjoy the triple tax benefit. Instead, taxpayers who fund HSAs in those states are forced on an arduous tax journey to report correctly.  The challenges these residents face might have a chilling effect on those taxpayers who want to integrate an HSA into their retirement strategy.

“Finance 101 tells me that the earlier I start, the longer it has to compound, the bigger my savings balance,” explains Anna Kissick, Director of HSA Business Development at Liberty Savings Bank.  She admits that for residents of California and New Jersey, not getting tax benefits would “force them to re-evaluate whether contributing to an HSA is worth it, even with the federal tax favored status.”

The first issue arises with funding the HSA.  As HSAs have grown in use, many taxpayers fund through employer plans.  For California and New Jersey taxpayers in this situation, their employer takes the tax deduction for the HSA in Box 1 of the W-2.  The employer then adds it back in Box 16 of the W-2 for state wages.

“Right around February and March, we get the question quite a bit from savvy employees who look at their W-2 and start to question why federal and state wages are different,” says Jeff Kronemeyer, CPA at PG&S Accountants and Advisors who prepares returns in Wildwood Crest, NJ. “They are surprised to find out the HSA contribution by the employee is taxable for state purposes.  It is an increase in their NJ wages.”

But that is only for taxpayers who fund through an employer plan.  For those taxpayers who self- fund, they may also need to go on their resident state return and make the adjustment to their federal Adjusted Gross Income (AGI).

Compounding Interrupted by Taxes

But the journey isn’t over yet.  In fact, that’s the simple part of the tax issue California and New Jersey taxpayers face.

The power of compounding is discussed ad nauseum in the financial planning and investment world.  That power works well within the HSA.  But for California, not only are the contributions taxable, but so is the growth.

“States that tax HSA contributions and growth are creating a disadvantage for HSA owners,” says Kissick. “When you compare two accounts, one that is tax favored, and another that isn’t, it is obvious which account is going to have a bigger balance after several decades of saving and investing.”

Yet the tax system doesn’t take this into account because for Federal purposes, this is a tax-free transaction.  But California residents need to report all the interest, dividends and capital gains inside their HSAs.  As a result, taxpayers in those state needs to get their monthly statements and calculate by hand the growth of the funds inside the IRA.

How to Solve This Problem

Until California and New Jersey comply with the federal rules, there are a few techniques that these taxpayers can employ to help mitigate the work involved.  First, as this is a retirement account, taxpayers need to take a long-term view with the investments in the HSA.  The best course of action may be to not actively trade the account, but instead consider using a target date retirement fund.

Second, rather than have automatic dividend investment, taxpayers could consider letting all the interest and dividend income accrue to make it easier to calculate the growth.  The cash then can be reinvested the following year.

There are some who advocate the use of Treasury Bonds in HSAs as they are not taxable for state purposes.  But the point of using an HSA for retirement is to invest the funds for the long term.  By only investing in Treasuries, it’s like letting the tail wag the dog.  It is easier for tax purposes, but the funds won’t grow at the pace needed.

Finally, for New Jersey residents, withdrawals from their HSAs can be deducted as a medical expense subject to a 2% floor.

Where To Go From Here

Ultimately California and New Jersey need to look at HSAs as another way to help their residents save for retirement.  The choice to fund shouldn’t cause a punitive tax situation – or derail one of the best retirement strategies available.

Kronemeyer is optimistic for his clients. “There is pending legislation to change the HSA rules in New Jersey.  The bill entered the NJ Legislature in January of 2019,” he says.

While this might be a solution for New Jersey, a California bill stalled in 2018.  It’s time for both states to move forward with making HSAs a powerful tax and retirement tool.