(GCC: Taxes and college tuition are 2 of the greatest expenses parents will face. But what if there was a tax hack that could reduce the cost of both? Today’s guest post shares the details… Read on!)
Hi Go Curry Cracker readers! I’m Kim from The Frugal Engineers. We are a family of three retiring in our thirties in Wyoming, and I’m here to talk tax hacking for college!
Over the last nine years of running our own engineering businesses, we’ve been tracking various tax optimization strategies. One of our favorite tax hacks is using our health savings account for college funds. By lowering our tax burden and maximizing our eligibility for college financial aid, we’re able to retire earlier and enjoy more time with our daughter. This post details part of our overall strategy for college planning in early retirement.
We max out our health savings account (HSA) each year that we’re eligible based on our health insurance. For a family of three in 2019 with a qualifying high deductible health insurance plan, that’s $7,000 a year. We pay cash for any medical, dental and vision expenses that we incur right now and save the receipts for reimbursement during the college years.
In fact, I refer to medical receipts as “future college tuition vouchers” in our house.
The Flexibility of Using an HSA for College Savings
My husband I both attended top colleges for engineering, and each school also has their own formula for calculating financial aid. Based on our research, this is an area where early retiring families can really shine with enough planning in advance.
By making plans a decade ahead of time, we’re able to maneuver our finances in a way that’s favorable for financial aid calculations.
A downside to traditional college savings plans is the penalty on using the funds if your child doesn’t go to college. Our daughter might choose to be an entrepreneur, a homemaker, enlist in the military, or any number of paths outside of college. By locking those dollars up in a 529 college savings account, we’d be looking at a 10% penalty to withdraw money for non-college expenses.
(GCC: And, you convert low/zero taxed long-term capital gains into highly taxed ordinary income! See why GCC Jr doesn’t have a 529.)
By earmarking our daughter’s college money in the HSA, it’s tax-deductible, able to grow tax-free, and able to be withdrawn tax-free at any time (as a reimbursement for previously incurred medical expenses).
How the HSA Wins the FAFSA Game
We just outlined how the HSA is triple tax-advantaged, but did you know it’s also double FAFSA-blind?
The Federal Application for Student Aid (FAFSA) is the application used to determine financial aid eligibility for college students. Based on your income, assets, and other factors, the calculations produce your Expected Family Contribution (EFC). This number is then used to determine how much “need” you have, which schools use to award aid. The EFC is also the number used to award federal grant money like Pell Grants.
By keeping college savings dollars in the HSA, you are not penalized for saving money in the eyes of the financial aid calculations.
The tricky thing about the FAFSA is that it looks at certain buckets of money differently. For example, home equity is not included as an asset in the calculations. This was another reason why we chose to pay off our mortgage early (in 2.5 years!) rather than investing the extra money in a taxable brokerage account.
(GCC: A clear example of when imputed rent is super to rent.)
The HSA dominates these calculations based on two notable rules:
- Health Savings Accounts are counted as “retirement” assets, which are excluded from the parental asset calculations.
- Withdrawals from HSAs to reimburse previously incurred medical expenses are not included as income on the FAFSA.
This means the HSA is double FAFSA-blind.
It’s worth pointing out that withdrawals from a Roth IRA are counted as income. Additionally, the assets inside a 529 plan are counted in the FAFSA calculations, while assets in IRAs (and other retirement accounts) are not.
Example of the HSA vs. 529 Impact on Financial Aid
Let’s run an example of an early retired family applying for federal financial aid. Our fictional FIRE family has one child, a paid-off home, and $1,000,000 in investments. This is broken out as $800,000 in tax-advantaged accounts like 401Ks and IRAs and $200,000 in an after-tax brokerage account.
Their annual spending is $40,000 (hence the 5 years of expenses in a brokerage account for the Roth IRA Conversion Ladder). The parents are 47 years old when their child enters college.
Additionally, this family has earmarked $84,000 for college savings (separate from their 25x spending for FIRE).
Using the EFC Calculator from the College Board, we can run the numbers on two different scenarios.
Scenario 1: $84,000 in a Health Savings Account (aka contributing the maximum $7,000 per year for 18 years of the child’s life)
Scenario 2: $84,000 in a 529 College Savings Plan
For the income calculations, we use an Adjusted Gross Income (AGI) of $40,000, which consists of converting money from a pre-tax IRA into a Roth IRA (aka Roth IRA Conversion) to cover one year’s living expenses.
For assets, let’s assume a buffer of three month’s expenses is held in cash/savings/checking ($10,000).
Here’s where we input savings.
For Scenario 1, the money in the Health Savings Account is not reported in this calculation.
For Scenario 2, the money in the 529 college savings account IS reported in the calculation.
For Scenario 1, we come up with an EFC of $3,596 each year.
For Scenario 2, the EFC is $6,333 each year.
By stashing the college savings in an HSA, we’re able to lower the Expected Family Contribution by $2,737 each year. Over the course of four years, that’s $10,948 in savings! Think of this as a $10,948 grant available to your child because you invested their college money in the best type of college savings account.
These calculations also don’t account for the tax savings throughout the parents’ careers from saving money in an HSA compared to a 529 (that’s funded with after-tax money).
HSA Best Practices
Bookkeeping for HSA Records
We keep both paper and digital copies of medical bills. For every doctor/dentist/pharmacy visit, we keep the original paper receipts (explaining the services rendered and confirming actual payment). Each receipt gets their own individual page protector and goes into a binder labeled “HSA”. This is so the paper receipts don’t fade as quickly and the ink doesn’t bleed in-between pages. We also keep a digital copy with a backup in case the paper receipts get lost. To tally all the receipts together, we use a spreadsheet listing the dates, healthcare provider, description of the service and the dollar amount paid.
Health savings accounts are great because you have the ability to use the funds to invest and grow even more over time. For example, Fidelity offers a free HSA option where you can invest in their zero-fee index funds (instead of keeping the money in cash for 18 years). We chose to use a total stock market index fund for our HSA to maximize growth since we have a twelve-year timeline until our daughter starts college. Depending on the market performance in high school, we may choose to reallocate some of these funds to cash (i.e. the funds which have receipts to back up withdrawals) in the years leading up to college.
What If You’re Healthy?
What happens if your family doesn’t incur the full $84,000 of medical expenses between birth and college age? There are a few things to note about this approach. First, count your blessings for 18 years of good health. Up to now, our family has not incurred as much in medical expenses annually as we contribute to our HSA, so we do have leftover money. That’s why the health care receipts themselves are the valuable “college tuition vouchers”. For example, if our HSA has a $12,000 balance but we only have $6,000 of receipts, we’d only plan to use $6,000 for college. If you have multiple children, you can keep the HSA dollars for the subsequent children’s college educations.
Remember, there are lots of things that count as IRS-Qualified Medical and Dental Expenses (pdf) and these small purchases can add up quickly. For example, prescription drugs, contact lenses and solution, dental treatments, doctor’s office visits/co-pays, eyeglasses, IVF, flu shots, laser eye surgery, orthodontics, pregnancy tests, special education for learning disabilities, speech therapy, and vasectomies.
(GCC: we keep digital copies of all of our IVF and childbirth receipts, which now exceed the total value of our HSA. The Office Lens app is amazing!)
The interesting thing about an HSA is that if you don’t use the money by the time you’re 65, it then gets treated like a traditional IRA and you can withdraw the money for any purpose without penalties (i.e. no need to back up withdrawals with medical receipts), although it would be taxable income at that point (just like an IRA withdrawal)
By prioritizing HSA contributions during our working years, we’re able to minimize our tax burden and increase federal financial aid for college by almost $11,000.
If you have college-bound children, I encourage you to run the numbers for your future family situation and get an idea of how moving money into various forms can impact the numbers. This advanced planning can save time and money down the road and help set your child up to graduate from college without a hefty student loan package.
*Note that I’m not an accountant, I just read a lot about this topic. If you want to read more, here are some links for details: