A health savings account, or HSA, is a tax-advantaged savings and investing account that was created in 2003 to help Americans pay for their out of pocket medical expenses.
A funded HSA can help offset out of pocket expenses, which are common if the insured has a high deductible health insurance plan.
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History of Health Savings Accounts
HSAs were established as part of the Medicare Prescription Drug, Improvement and Modernization Act, which included the enactment of Internal Revenue Code section 223 (PDF).
HSA accounts were signed into law by President George W. Bush on December 8, 2003.
To qualify for a HSA, an individual must have a health insurance plan with an annual deductible of at least $1,400 for single coverage and $2,800 for a family, these requirements are changed annually by the Internal Revenue System (IRS).
Another requirement for opening a HSA is that the individual’s health plan must also meet an out-of-pocket maximum that is below a specified threshold. Currently, the out of pocket maximum for an HSA qualified health plan cannot exceed $7,050 for self-only coverage or $14,100 for family coverage.
|Qualifications||Self-Only Health Coverage||Family Health Coverage|
|Annual Out-of-Pocket Costs(maximum)||$7,050||$14,100|
While millions of people qualify, few take advantage of the numerous benefits offered by HSAs. The biggest reason why many people who are eligible do not open these accounts is because they do not know that they exist.
Health Savings Account Benefits
Contributions to HSAs are tax-deductible, and withdrawals for qualified healthcare expenses are tax free.
Health savings accounts (HSAs) are essentially personal investment accounts, but the funds can only be used to pay for health care expenses. The individual, not the employer or insurance company, owns and controls the money in the HSA.
If an individual does not use HSA funds in a given tax year, they carry over to the next year. The flexibility is a major benefit for paying healthcare expenses. After all, the need for healthcare is often unpredictable.
Medical Costs Covered With an HSA
The IRS provides a list of expenses that qualify for HSA tax-free distributions in Publication 502, but these are a few of the most common medical expenses:
- Prescription medications
- Nursing services
- Long-term services
- Dental care
- Psychiatric care
- Surgical expenses
- Fertility treatments
Who Should Open a Health Savings Account?
Individuals should evaluate HSA funding in the context of their household budget. A person should also consider if they have any planned upcoming medical expenses. For example, if you need a hip replacement in the next two years, it might be prudent to start funding an HSA account.
Individuals who are healthy and want to save for future health care expenses may find that an HSA is an attractive choice.
For those near and saving for retirement, an HSA might make sense because the money can be used to offset the costs of medical care after retirement.
To summarize, here are advantages and disadvantages of HSA accounts:
- Individuals have the flexibility to decide how much to save for health care costs.
- The HSA account owner/holder decides how the money is spent and allows participants to shop around for care based on quality and cost.
- The employer may contribute to the HSA, but the individual owns the account and can keep the money even if he or she changes jobs.
- Unused money at the end of the year rolls over (stays in the account) to the next year and remains in the account indefinitely.
- The account holder does not pay taxes on money going into the HSA, which provides a tax benefit today. If the HSA funds are used for qualifying medical expenses, the money comes out of the HSA tax-free.
- Some HSAs pay interest on the money in the account or allow the account holder to invest the money in mutual funds or other financial products. The investment earnings from an HSA are tax-free if used for qualifying medical expenses.
- Illness can be unpredictable, which makes it hard to accurately budget for future health care expenses.
- People that are healthy might find it unnecessary to save for health care expenses. This could leave them in a financial bind if an unexpected health care event occurs.
- If the account owner withdraws money out of the HSA for non-medical expenses, he or she will have to pay taxes on it.
- Investment decisions within the HSA are made by the account owner. This can be overwhelming for those without investment experience.
- Funding an HSA outside of an employer sponsored plan can be confusing. There are eligibility requirements, private exchanges, and tax considerations.
Employers may offer an HSA option, or an individual can open an account on his or her own through a private exchange, financial or banking institution. To qualify, an individual must be under age 65 and have a high-deductible health insurance plan (see limits above).
If a spouse uses your insurance as secondary coverage, he or she also must be enrolled in a high-deductible plan.
This high-deductible health plan must be a person’s only health insurance. However, having dental, vision, disability and long-term care insurance is not a disqualification from opening a HSA.
Individual Contribution Limits
For people who are eligible to participate in a Health Saving Account, the amount that can be contributed to the account depends if it is individual health coverage or a family health plan. HSA contribution limits are set annually by the IRS. The limits are $3,650 for self-only coverage and $7,300 for a family.
In addition to these limits, HSA participants who are 55 and older can contribute an additional $1,000 as a catch-up contribution. A 55-year-old account holder, with self-only coverage, can contribute up to $4,650 per year, and $8,300 if he or she is the primary insured on a qualifying family health plan.
If the employer makes contributions to HSAs for its employees, these funds are counted toward the annual limit. For example, if an employee has self-only coverage with a $3,650 contribution limit and the employer places $1,000 in the account for the year, the employee can only contribute the remaining $2,650.
HSA contributions can be made until the April tax deadline in any given year. Generally, the deadline falls on April 15th, but it can differ slightly due to weekends or holidays.
Tax Advantages of an HSA
For individuals who are eligible to contribute to a HSA, the contributions are tax-deductible up to the annual contribution. For example, an account holder who is under 55 and has family coverage, contributing the maximum to the HSA will lower taxable income by $7,300.
The funds invested within a HSA grow on a tax-deferred basis. This is the same tax deferral that occurs in an IRA and 401(k), which means that the account holder does not have to pay taxes on capital gains, interest income, or dividends received within the account.
Distributions from the HSA that are used to pay for qualified health-care expenses are 100% tax-free.
The Bottom Line
A Health Saving Account (HSA) is a wonderful way to set aside money on a tax-deferred basis for medical expenses, but with the added ability to invest and carry over funds from year to year.
If used as a long-term vehicle, the HSA can literally save tens of thousands of dollars on health-care costs after retirement, while potentially saving thousands in taxes during the funding phase.