A health savings account, or HSA, is a tax-advantaged savings and investment account that was created in 2003 to help Americans with high-deductible health insurance plans save for their out-of-pocket medical expenses.
What is a High-Deductible Health Insurance Plan?
As its name implies, they are health insurance plans with high deductibles — the amount of medical expenses the policyholder must pay each year before medical coverage kicks in. These types of plans are becoming increasingly common. Businesses are becoming more likely to offer them to employees as their only plans or as one of the limited options they provide.
While the deductible is high with this type of plan, the premium (the regular fee paid to obtain coverage) is typically lower than it is for traditional plans.
HSAs were established as part of the Medicare Prescription Drug, Improvement and Modernization Act, which included the enactment of Internal Revenue Code section 223, and the accounts were signed into law by President George W. Bush on December 8, 2003.
Contributions to HSAs are tax-deductible, and withdrawals for qualified health-care expenses are tax-free as well. For detailed information on HSAs, the U.S. Treasury maintains an online guide.
To qualify for an HSA in 2020, 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 an HSA is that the individual’s health plan must also meet an out-of-pocket maximum that is below a specified threshold. For 2020, the out-of-pocket maximum for an HSA-qualified health plan cannot exceed $6,900 for self-only coverage or $13,800 for family coverage.
|Qualifications||Self-Only Health Coverage||Family Health Coverage|
|Annual Out-of-Pocket Costs(maximum)||$6,900||$13,800|
While millions of people qualify, few take full 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 accounts (HSAs) are like personal savings accounts, but the funds in them can only be used to pay for health care expenses. The policy holder — not the employer or insurance company — owns and controls the money in the HSA.
An HSA is rather different from a flexible spending account, or FSA, even though they are both tax-advantaged vehicles for health-care savings. With an HSA, unlike an FSA, the money contributed to the account can be invested and the policy holders are able to carry over the funds from year to year.
Why Were Health Savings Accounts Created?
HSAs were created as a way to help control health care costs. The rationale for creating these plans is that people will probably spend their health care dollars more wisely if they’re using their own money.
What Medical Costs Can be Paid with an HSA?
What are the allowable reasons to take tax-free distributions from an HSA? The IRS provides a thorough list of expenses that qualify for HSA tax-free distributions in Publication 502, but these are a few of the most common medical bills:
- Prescription medications
- Nursing services
- Long-term services
- Dental care
- Psychiatric Care
- Surgical expenses
- Fertility treatments
Who Should Open a Health Savings Account?
Individuals have to think about their budgets and what health care they expect to need in the next year, which can be difficult to estimate.
Individuals who are generally healthy and want to save for future health care expenses may find that an HSA an attractive choice. Or for those near retirement, an HSA may make sense because the money can be used to offset the costs of medical care after retirement.
However, an HSA may not be the best option for individuals who will likely require expensive medical care in the next year and will find it hard to meet a high deductible.
What are some potential advantages of health savings accounts?
- Individuals decide how much money to set aside for health care costs. The account holder decides how the HSA money is spent and the accounts allow people 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.
- Any 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.
- Some HSAs pay interest on the unused money in the account or allow the account holder to invest the money in mutual funds or other financial products. The earnings from an HSA are also tax-free.
What are some potential disadvantages to health savings accounts?
- Illness can be unpredictable, which unfortunately makes it hard to accurately budget for future health care expenses.
- It can be difficult to obtain information about the cost and quality of medical care.
- Some people find it challenging to set aside money to put into their HSAs. People who are older and sicker may not be able to save as much as younger, healthier people.
- Pressure to save money in the HSA might lead the account holder to forgo medical care when it is necessary.
- If the account holder withdraws money out of the HSA for non-medical expenses, he or she will have to pay taxes on it.
Who Can Set up a Health Savings Account?
Employers may offer an HSA option, or an individual can start an account on his or her own through a bank or other financial institution. To qualify, an individual must be under age 65 and have a high-deductible health insurance plan.
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 an HSA.
How Much Can An Individual Contribute?
For people who are eligible to participate in an HSA, 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; for 2020, the limits are $3,550 for self-only coverage and $7,100 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. So a 55-year-old account holder with self-only coverage can contribute up to $4,550 per year, and $8,100 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 $3,550 contribution limit and the employer places $1,000 in the account for the year, the employee can only contribute the remaining $2,550.
HSA contributions can be made until the April tax deadline in any given year. Generally it is on April 15, but it can differ slightly due to weekends or holidays.
Tax Advantages of an HSA
For individuals who are eligible to contribute to an 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 $7,100.
The funds invested within an HSA grow on a tax-deferred basis. This is the same tax deferral that occurs in an IRA, 401(K) or other investment vehicle, which means that the account holder does not have to pay annual taxes on capital gains, interest income or dividends that occur within the account.
Withdrawals from the HSA that are used to pay for qualified health-care expenses are 100% tax-free.
The Bottom Line
An 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 investment vehicle, the HSA can literally save tens of thousands of dollars on health-care costs after retirement, while also saving thousands on taxes in the meantime.