Are HSAs Worth it in California?

HSAs are often touted as the best tax-advantaged tool out there, since if they're used for qualifying medical expenses, they're "triple tax-free". Contributions are made pre-tax (and without Social Security and Medicare taxes too if contributed through payroll), growth is tax-deferred, and qualifying distributions aren't taxed either. Contrast that with a pre-tax 401k, which are subject to Social Security and Medicare (payroll) taxes on the way in, and federal income tax on the way out. Of course, you need to be eligible to participate in an HSA to take advantage of it, but that applies to any tax-advantaged vehicle.

That’s great on the federal level and for most states, but in California (and New Jersey), HSAs aren’t exempt from state income tax. This means that while Californians can still enjoy the triple tax-free benefit federally, contributions, growth, and earnings are all taxed at the state level. For a single Californian making between $61,215 and $312,686 (double those numbers if married filing jointly), that’s a 9.3% marginal tax rate.

To answer the question, "are HSAs worth it in California?", let's look at the tax differences between HSAs and pre-tax 401ks, which enjoy pre=tax contributions (no payroll tax exemption), tax-deferred growth, and income taxes on distributions.

Payroll taxes cap out at 8.55%, and you’re paying that much only when you’re married and have joint earnings over $250,000, but your individual earnings are less than the $147,000 Social Security wage base. The calculation for the 8.55% payroll tax is: 6.2% Social Security tax for individual earnings under $147,000, 1.45% Medicare tax for all earnings, and 0.9% additional Medicare tax for joint earnings above $250,000. This requires a pretty specific situation, and you're likely paying less on most, if not all of your earnings. I'm using 8.55% to highlight the highest payroll tax rate you might pay on some or all of your earnings as an employee.

On the way in (contributions), it sure seems like a pre-tax 401k comes out ahead. But let’s move on to the next part: taxes on earnings within the HSA.

Like in a 401k, earnings in an HSA are tax-deferred on the federal level. That means interest, dividends, and capital gains from selling investments aren’t subject to federal income tax, as long as you don’t take a distribution. But in California? No such luck. If your HSA investments pay taxable interest or dividends, or if you sell something at a gain, you'll owe California income tax in that year.

HSAs are really starting to look like a bad deal in California. Let’s see if things turn around when we talk through taxes on distributions…

As mentioned earlier, when you take a distribution from your HSA to pay for qualifying medical expenses, you don't pay any federal taxes. Additionally, since California considers your HSA as not tax-qualified (essentially the same as a normal taxable brokerage account), distributions are only taxed to the extent that selling an investment realizes a gain. Contrast that with pre-tax 401k distributions, which are fully taxable as ordinary income on the federal and California state levels.

*Although you’ll owe California state income tax on gains from the investments you sell, that technically falls under the above section for taxes on earnings within the account. What you won't have is California income tax on your entire distribution.

Ultimately, this means you don’t ever have to pay any federal taxes on your HSA if the distribution pays for qualifying expenses. That’s huge. Because of that, it’s pretty clear to me that an HSA is still worth it in California from a tax perspective in spite of the state tax impact, as long as it’s used for qualifying medical expenses.

A disclaimer here: this is based on the earlier tax bracket assumptions and a tax-aware investment strategy. If your HSA generates a significant amount of California taxable income annually, if you’re in the 12.3% or 13.3% California tax brackets, or if your federal tax bracket at withdrawal is expected to be 0% or 10%, an HSA may not be obviously better from a tax perspective.

HSA Recordkeeping in California

Since HSAs are tax-qualified on the federal level, your account likely won't generate Form 1099s to track cost basis, income earned, and capital gains realized. In those cases, the cost basis of holdings, income generated, capital gains realized, and capital losses incurred must be tracked manually for California tax purposes. Your HSA custodian may be able to provide you with some or all of this information, but you're ultimately responsible for accurate recordkeeping and reporting.

As a result, if you make frequent trades in your HSA or have holdings that automatically generate income or distribute gains, there’s going to be more to keep track of, and more to report to the FTB. On the other hand, if you only rebalance periodically and select tax-efficient investments, you’ll have fewer things to track annually. Recordkeeping can be a headache, but it's critical to avoid getting taxed multiple times on the same earnings.

This recordkeeping and reporting requirement specifically for California taxes might be enough to deter you from participating in an HSA. I personally see the benefits outweighing this burden, but it comes down to how you feel about it in the context of your financial situation.

What if I’m Going to Use My HSA as a Retirement Account?

If you decide to use your HSA as a retirement account and take distributions for non-medical purposes, federal income taxes apply (no penalties after age 65, but an additional 20% penalty if under 65 or not meeting another exemption). Because you’re no longer completely tax-free on the federal side, an HSA starts to look a lot less compelling in California if used as a retirement account.

However, given how our healthcare system is structured, you’ll probably be able to find a qualified use for a good chunk of your HSA. In fact, as long as your HSA was already established when a qualifying expense is incurred, you can reimburse yourself today, tomorrow, or 50 years from now. Just make sure to keep records in case of an IRS audit. And in the event you have absolutely perfect health and the most robust medical coverage in existence, you might not even care that you overprepared. I know I won't be too upset if I could get through the next 35 years without any significant medical costs.

At the end of the day, if an HDHP is appropriate from a financial and risk standpoint, contributing to an HSA alongside it is probably logical, even in California. I'm sure there are edge cases where it doesn't make sense, but I haven't come across any yet. If you're starting a new job or reevaluating your healthcare options and want to make sure you're making the right decisions for yourself and your family, I'm happy to help you evaluate your options.