Health Savings Account (HSA) Explained

Investopedia / Paige McLaughlin

 

What Is a Health Savings Account (HSA)?

A Health Savings Account (HSA) is a tax-advantaged account created for or by individuals covered under high-deductible health plans (HDHPs) to save for qualified medical expenses. Contributions are made into the account by the individual or their employer and are limited to a maximum amount each year.

The contributions to an HSA are invested over time and can be used to pay for qualified medical expenses, such as medical, dental, and vision care and prescription drugs.

KEY TAKEAWAYS

• A Health Savings Account (HSA) is a tax-advantaged account to help you save for medical expenses that are not reimbursed by high-deductible health plans (HDHPs).
• No tax is levied on contributions to an HSA, the HSA’s earnings, or distributions used to pay for qualified medical expenses.
• An HSA, owned by an employee, can be funded by the employee and the employer.
• Contributions are vested, and unused account balances at year-end can be carried forward.

How an HSA Works

As mentioned above, people with HDHPs can open HSAs. Individuals with HDHPs may qualify for HSAs, and the two are usually paired together. To qualify for a Health Savings Account (HSA), you must meet eligibility standards established by the Internal Revenue Service (IRS). To be eligible, you must:

• Have a qualified HDHP
• Have no other health coverage
• Not be enrolled in Medicare
• Not be claimed as a dependent on someone else’s tax return

The maximum contribution for an HSA in 2024 is $4,150 for an individual ($3,850 for 2023) and $8,300 for a family ($7,750 in 2023).23 The annual limits on contributions apply to the total amounts contributed by both the employer and the employee. Individuals age 55 or older by the end of the tax year can make catch-up contributions of an additional $1,000 to their HSAs.4

An HSA can also be opened at certain financial institutions. Contributions can only be made in cash, while employer-sponsored plans can be funded by the employee and their employer. Any other person, such as a family member, can also contribute to the HSA of an eligible individual. Self-employed or unemployed individuals may also contribute to an HSA, provided that they meet the eligibility requirements.5Individuals who enroll in Medicare can no longer contribute to an HSA as of the first month of enrollment.6 However, they can receive tax-free distributions for qualified medical expenses.

HSA Special Considerations

HDHPs have higher annual deductibles (the plan pays nothing until you reach these amounts in out-of-pocket expenses) but lower premiums than other health plans.7 The financial benefit of an HDHP’s low-premium and high-deductible structure depends on your personal situation.

The minimum deductible required to open an HSA is $1,600 for an individual or $3,200 for a family for the 2024 tax year ($1,500 and $3,000, respectively, for 2023). The plan must also have an annual out-of-pocket maximum of $8,050 for self-coverage for the 2024 tax year ($7,500 for 2023) and $16,100 for families for the 2024 tax year ($15,000 for 2023).83

When you pay qualified medical expenses equal to a plan’s deductible amount, additional qualified expenses are divided between you and the plan.

Example of HDHP

For example, the insurer may cover a percentage of the qualified expenses per the contract (usually 80% to 90%), while you may pay the remaining 10% to 20% or a specified co-pay.

So, if you had an annual deductible of $1,600 (in 2023) and a medical claim of $3,500 pays the first $1,600 to cover the annual deductible. You would pay 10% to 20% of the remaining $1,900, and the insurance company would cover the rest.

Once the annual deductible is met in a given plan year, the plan typically covers any additional medical expenses, except for any uncovered costs under the contract, such as co-pays. The insured can withdraw money accumulated in an HSA to cover these out-of-pocket expenses.9

 

Health savings accounts should not be confused with health spending accounts, which employers use in Canada to provide health and dental benefits for their Canadian employees.10

 

Advantages and Disadvantages of an HSA

HSAs have advantages and drawbacks. The effect of these accounts depends on your personal and financial situations.

Pros

• Contribution tax advantages

• Distribution tax advantages

• Investment options

Cons

• Deductible requirements

• Requires extra cash

• Filing requirements

Pros Explained

Contribution tax advantages: Employer and individual contributions by payroll deduction to an HSA are excluded from the employee’s taxable income. An individual’s direct contributions to an HSA are 100% tax deductible from the employee’s income. Earnings in the account are also tax free. However, excess contributions to an HSA incur a 6% tax and are not tax deductible.11

Distribution tax advantages: Distributions from an HSA are tax-free, provided that the funds are used for qualified medical expenses as outlined by the IRS. Distributions used for medical expenses covered under the HDHP plan are included in determining if the HDHP’s deductible has been met.12

Investment options: You can also use the money in your HSA to invest in stocks and other securities, potentially allowing for higher returns over time.13

Cons Explained

Deductible requirements: The most obvious key drawback is that you need to be a good candidate for an HDHP. In addition, you must have a high-deductible plan, lower insurance premiums, or be affluent enough to afford the high deductibles and benefit from the tax advantages.

Requires extra cash: Individuals who fund their own HSAs, whether through payroll deductions or directly, should be financially capable of setting aside an amount that would cover a substantial portion of their HDHPs’ deductibles. Individuals without enough spare cash to set aside in an HSA may find the high deductible amount burdensome.

Filing requirements: HSAs also come with filing requirements regarding contributions, specific rules on withdrawals, distribution reporting, and a record-keeping burden that may be difficult to maintain.14

Withdrawals Permitted Under an HSA

Amounts withdrawn from an HSA aren’t taxed as long as they are used to pay for services that the IRS treats as qualified medical expenses. The plan's manager will issue an IRS Form 1099-SA for distributions from the HSA. Here are some basics you need to know:

• Qualified medical expenses include deductibles, dental services, vision care, prescription drugs, co-pays, psychiatric treatments, and other qualified medical expenses not covered by a health insurance plan.1516
• Insurance premiums don’t count as a qualified medical expense unless the premiums are for Medicare or other healthcare coverage (provided you are age 65 or older) for health insurance when receiving healthcare continuation coverage (COBRA), for coverage when receiving unemployment compensation, or for long-term care insurance, subject to annually adjusted limits. Premiums for Medicare supplemental or Medigap policies are not treated as qualified medical expenses.17

If distributions are made from an HSA to pay for anything other than a qualified medical expense, that amount is subject to both income tax and an additional 20% tax penalty. However, once an individual turns 65, the 20% tax penalty is eliminated, and only income tax would apply for non-qualified withdrawals.18

HSA Contribution Rules

Contributions made to an HSA do not have to be used or withdrawn during the tax year. Instead, they are vested, and any unused contributions can be rolled over to the following year. Also, an HSA is portable, meaning that if employees change jobs, they can still keep their HSAs.1

An HSA plan can also be transferred to a surviving spouse tax-free upon the account holder’s death.19

However, if the designated beneficiary is not the account holder’s spouse, then the account is no longer treated as an HSA, and the beneficiary is taxed on the account’s fair market value, adjusted for any qualified medical expenses of the decedent paid from the account within a year of the date of death.

HSA vs. Flexible Spending Account

The HSA is often compared with the Flexible Spending Account (FSA). While both accounts can be used for medical expenses, some key differences exist between them:

• FSAs are employer-sponsored plans.
• Only employed individuals can sign up for FSAs.
• Unused funds in the FSA during a given tax year can’t be rolled over and are forfeited once the year ends.
• Your elected contribution amount for an FSA is fixed, unlike HSA contributions.20

The maximum contribution for an FSA for the 2024 tax year is $3,200 ($3,050 for 2023).2122

Can I Open a Health Savings Account (HSA) If I’m Self-Employed?

You can open a Health Savings Account (HSA) if you have a high-deductible health plan. If you are self-employed, you can look into HSAs offered by brokerages or banks like Fidelity, HealthEquity, or Lively. Research your options carefully to ensure you get the best HSA to suit your needs.

Do I Have to Use All of the Money in My HSA Every Year?

Unlike a Flexible Spending Account (FSA), contributions to your Health Savings Account (HSA) can roll over yearly. Since the funds can also be invested, you can build capital for more significant medical needs or use it as an investment fund after retirement.23

Can I Pay My Insurance Premiums with My HSA Funds?

In most cases, you cannot pay for premiums with Health Savings Account (HSA) funds. HSAs can be used for most medical expenses, like doctor’s appointments, prescriptions, or over-the-counter medications, but not your monthly premium. The only exception to this rule is when the funds are used to pay Medicare premiums or other healthcare continuation coverage, such as COBRA, while you’re on unemployment compensation. You may also pay for long-term care insurance using your HSA.24

The Bottom Line

HSAs are one of the best tax-advantaged savings and investment tools available under the U.S. tax code. They are often referred to as triple tax-advantaged because:

• Contributions are not subject to tax.
• The money can be invested and grown tax free.
• Withdrawals are not taxed as long as you use them for qualified medical expenses.

As a person ages, medical expenses tend to increase, particularly when reaching retirement age and beyond. Therefore, starting an HSA early if you qualify—and allowing it to accumulate over a long period—can benefit your financial future.