Health savings accounts (HSAs) let you save money to cover the cost of a wide range of qualified medical expenses. HSAs offer a trio of tax advantages, and you can invest the money saved in an HSA in markets for better returns on your contributions.
Just note that HSAs are only available if you have a high-deductible health plan (HDHP). If you have this type of healthcare coverage, you can’t afford to miss out on the many benefits of HSAs. Here’s what you need to know.
How Does an HSA Work?
HSAs are designed to help people with high-deductible health plans save money tax-free to pay for deductibles and copayments, among other qualified medical expenditures.
While the federal government has tried to steer Americans into HSAs and has made HSAs widely available in recent legislation, the plans haven’t resonated with their intended audience. A recent study by Further, an HSA administrator, found that 40% of respondents who have access to health savings accounts don’t fully understand how they work.
This is regrettable because HSAs offer a trifecta of tax benefits that should not be overlooked:
Contributions to an HSA account come out of your paycheck before income taxes, which lowers your tax liabilities in the present.
Money saved in the account may be invested in mutual funds, stocks and exchange-traded funds (ETFs); all investment gains are sheltered from taxes, like with 401(k)s or individual retirement accounts (IRAs).
Withdrawals from an HSA that are made to pay for qualified expenses are free of income taxes.
Access to HSAs is limited to workers with high-deductible health plans. For 2021, the IRS defines an HDHP as any health care plan with a deductible of at least $1,400 for an individual or $2,800 for a family. Total out-of-pocket expenses—including deductibles, copayments, and coinsurance—are limited to a total of $7,000 for an individual or $14,000 for a family. But these limits don’t apply to out-of-network services.
If you are eligible to contribute to an HSA, the annual HSA contribution limit is $3,600 for individuals and $7,200 for families for 2021. People who are age 55 and older can make an additional $1,000 in annual catch-up contributions. Like an IRA, your final contribution deadline is your tax deadline, normally April 15, for the year prior.
Employers can also contribute to their employees’ HSA accounts. But unlike with most retirement accounts, contribution limits are inclusive of employee and employer contributions. Regardless of whether your employer contributes, you’ll need to be careful when setting up your payroll deductions for an HSA. If you contribute too much, the Internal Revenue Service (IRS) may impose a 6% tax on the excess contribution.
What happens when you make HSA withdrawals depends on what you use the funds for and when you do it. You can make tax-free withdrawals from your HSA for qualified medical expenses at any time. If the expenses do not qualify, you may incur a 20% penalty plus taxes on what you withdraw. This is only not true if you are 65 or older, in which case you can avoid the penalty and only owe income taxes.
If you make an ineligible withdrawal, your HSA provider may allow you to recontribute it, depending on its policies.
HSA Eligible Expenses
The IRS provides a comprehensive list of medical services that are eligible to be paid for with HSA funds. Typical expenses for the 2020 tax year included:
General medical expenses
Prescriptions and some over-the-counter medications
Dental and orthodontics expenses
Eyeglasses, vision exams and other services that may not typically be covered under insurance plans, like laser eye surgery
Weight loss programs, compression socks and massage therapy, if medically necessary
The two big advantages of an HSA are immediate tax savings and long-term tax-free investment growth. This last part is sorely underutilized, however, with only about 4% of HSAs containing invested dollars.
This is unfortunate because “an HSA offers the best of a traditional IRA and a Roth IRA in one account,” says Logan Allec, a certified public accountant (CPA) and founder of the website Money Done Right. Contributions lead to tax deductions today, like with a traditional IRA, invested funds grow tax free, like both kinds of retirement accounts, and money withdrawn for qualified medical expenses is never taxed, like withdrawals from Roth accounts, Allec says.
And, as noted above, once you turn 65, your HSA waives the normal 20% penalty on ineligible expenses, effectively transforming into a traditional IRA, though it still retains Roth-like properties if you use it for medical costs.
It’s also important to note that you can retroactively pay yourself back for medical expenses, even if they happened years before, as long as you have receipts. This means you can access funds tax free by reimbursing yourself for prior costs, even if you aren’t necessarily currently using the money for medical expenses. When combined, all of these features can make HSAs a key part of your retirement plan.
HSA vs FSA: Similarities and Differences
When it comes to tax-advantaged medical savings, many people are more familiar with flexible spending accounts (FSAs) than HSAs. While they are similar tools, as both provide tax-advantaged ways to cover the costs of medical care, there are important differences between the two.
The main difference is that FSA funds must be used during the plan year or you forfeit the money. “Most employers allow for a rollover of a small amount or a carry over to the next year,” says Louis Bernardi, an insurance broker at Group Planners Inc., in Woodbury, N.Y. “HSAs, on the other hand, do not expire and belong to the individual.” This means you can carry them with you across your life and career. FSA funds, on the other hand, are normally forfeited soon after you leave your current employer.
Eligibility is the other big difference. If your employer offers an FSA, you’re eligible, whether you have several health plans or none. But to qualify for an HSA, you must be enrolled in an HDHP.
It’s also important to note that you may be able to open an FSA and an HSA if you have an HDHP and your employer offers both account types. In this instance, however, your FSA is termed a “limited-purpose FSA” and can only be used for dental and vision expenses.
Health savings accounts are offered by banks and financial services firms. Your employer may have a partner HSA provider already available to you, though you are always free to use an outside HSA. Contributions may simply not be automatically deducted from your paycheck if you choose that option.
Fees and account perks differ among HSA providers. Notably, not all providers allow you to invest funds immediately. Some have balance thresholds you must meet to begin investing. Investment options available also vary widely among firms.
The following HSA administrators have investment thresholds:
Further requires a balance of $1,000 in your HSA account before you can start investing in mutual funds. You can choose from a selection of Charles Schwab mutual funds when your account value is $10,000 or less. You need a balance of more than $10,000 before you can access a wider selection of mutual funds and other securities.
Optum Bank has an investment threshold of $2,000, but there’s a hitch. You must maintain a cash balance of $2,000. Any contributions above this amount may be investing in a selection of around 30 mutual funds. Notably, if you make a withdrawal from your HSA cash, investments will be sold to bring the cash balance back to $2,000 if contributions are not made to bring it back to equilibrium.
Select HSAs permit so-called “first-dollar investing,” where money is put to work in securities with no investment threshold. These three HSA firms have no investment threshold:
Be aware that some providers may charge maintenance fees, fees to begin investing or trading fees. You’ll want to be fully aware of providers’ potential costs before you fund an account with one.
Tax Forms to Use with an HSA
If you contribute to or use funds from an HSA, you’ll need to be on the lookout for certain forms come tax season. The IRS requires HSA users to file two tax forms along with their annual tax returns.
IRS Form 8889. This form covers all contributions and withdrawals to and from your HSA in a given tax year “It’s required if any HSA contributions have been made to your HSA, you have withdrawn money from your HSA or if you’ve inherited an HSA upon the death of the owner,” says Nancy Giacolone, president of Olympic Crest Insurance, Inc. in Gig Harbor, Wash.
IRS Form 1099-SA. This form documents HSA withdrawals. It’s sent to HSA users at the end of January, already filled out by the HSA custodian and should be used to help complete IRS Form 8889. You may receive multiple 1099-SA forms if you made withdrawals from multiple HSAs, switched HSA providers during the year or inherited another person’s HSA.
Should You Contribute to an HSA?
If you’re eligible for an HSA plan and have the extra cash needed to make contributions, it can be a highly useful financial tool that provides funds for medical care, solid tax benefits and a potential retirement savings feature.
To use it effectively for that last item, though, you may have to reframe how you view your HSA, says Jarrod Winkcompleck, a health savings advisor at Gap Financial Services in Austin, Texas. That means transitioning from viewing HSAs as a go-to source for medical costs now. Instead, you’ll want to start treating it like a retirement account. Only once you near retirement can you start thinking again about it in terms of medical expenses.
“If you “max fund” an HSA annually and do not use the funds for current medical expenses, the funds can accumulate significantly and help pay medical costs and long-term care needs in retirement,” he says.