Are you interested in using pre-tax dollars to cover your healthcare expenses? If so, a Health Savings Account could be the answer.
A Health Savings Account is a type of employee benefit that helps you save money on eligible health care expenses. It is commonly offered as an employee fringe benefit. When used effectively, this method of health coverage can offer significant benefits that can help maintain your physical and financial well-being.
However, HSA provisions can be confusing. That’s why we’ve put together this guide to answer your questions. Select among the topics below to learn more:
- What is a Health Savings Account?
- How Does a Health Savings Account Work?
- How Much Can You Contribute to a Health Savings Account?
- Withdrawing from Health Savings Accounts
- What Expenses Do Health Savings Accounts Cover?
- What is the Difference Between HSA and FSA?
- What are the Benefits and Drawbacks of an HSA?
- What Happens to Unused Funds in a Health Savings Account?
- Key Takeaways
What is a Health Savings Account?
A Health Savings Account (HSA) is a medical savings account offering tax benefits and investment options. It can be used for medical expenses that may not be included in your health insurance coverage, such as fertility treatment or crutches. Eligible healthcare expenses include dental services and vision expenses for yourself, your partner, or eligible dependents like children, parents, and anyone considered exempt under Section 152 of the U.S. tax code.
HSAs also offer the option to invest funds in stocks and bonds. Consider it a conventional IRA, a retirement savings account that offers pre-tax dollar contribution advantages but with the restriction that the funds can only be utilized to cover medical costs. Like an IRA, HSAs have their own contribution limits and withdrawal regulations according to the IRS.
The versatility of an HSA can be attractive, but it also has its downsides, such as limitations on investment options and usage. It is necessary to have a High-Deductible Health Plan (HDHP) to participate. We will cover the definition of HSA, its functioning, and other related aspects.
How Does a Health Savings Account Work?
The HSA is widely recognized as one of the most tax-efficient accounts due to its “triple tax advantage.” Here is how it works:
Pre-tax Deductions
If you have an employer-sponsored HSA, your contributions are deducted from your income before taxes are applied. Depositing funds not directly from your payroll makes them eligible for a tax deduction. In 2022, the maximum limit for single-insured individuals is $3,650, while for families, it is $7,300. Individuals 55 or older are eligible for a $1,000 increase in each limit. These limits include any contributions made by an employer.
You can earn interest over time by keeping the funds in the HSA for eligible health care expenses. Although interest rates are typically meager, and any earnings will be minimal, it is advisable to invest your HSA funds. In case you have to pay a medical bill, you can sell the investments to gain access to the savings.
To receive a health reimbursement arrangement for your upcoming medical bills, submit the receipt to your HSA provider. They will then supply you with the necessary funds to cover the health care expense.
Tax-free Interest Earnings and Investment Growth
One additional tax benefit of having an HSA is that any increase in the value of your funds is not subject to taxation. If you choose to invest in an S&P 500 index fund and the value of the funds increases, you will not be taxed on that growth. Certain HSA accounts may require you to maintain a minimum balance in the account in addition to any investments you make.
Tax-free Withdrawal for Qualified Healthcare Expenses
The third layer of tax considerations for health savings accounts is that you can withdraw funds from your account without tax if the withdrawal is for qualified medical costs.
Retirement Account
However, if you prefer to refrain from utilizing the funds for healthcare-related expenses, there is a potential solution. By waiting until you reach the age of 65, you will be able to withdraw the funds for any purpose. There are no fees for penalties associated with this action. However, the funds will be liable for income tax, just like a traditional IRA.
Optimizing a Health Savings Account
Ideally, the best way to utilize an HSA is to deposit funds, invest them, and only withdraw them once you reach the age of 65. Suppose you made a monthly deposit of $100 into an HSA and supported the entire amount into an S&P 500 index fund for 30 years, assuming an 8% return.
In this scenario, your total investment of $36,000 would yield over $146,000. If you have medical costs, using the funds to set money aside tax-free is an excellent option.
How Much Can You Contribute to a Health Savings Account?
To contribute to your Health Savings Account, you must be enrolled in a qualified high-deductible health plan without any disqualifying coverage. Various individuals, including household members, friends, and employers can also contribute to your HSA.
The following table shows contribution limits for an HSA in 2022 and 2023. The limits for your Health Spending Account may vary depending on factors such as your high deductible health plan coverage (individual or family), your age, and when you incur eligible expenses.
Individuals aged 55 or above can contribute $1,000 annually to their HSA, known as a “catch-up” contribution. If your spouse is 55 or older and meets the eligibility criteria, they can make a catch-up contribution to their account. However, they cannot make a catch-up contribution to your account.
Withdrawing from Health Savings Accounts
Withdrawals made from your HSA to cover qualified medical care expenses are exempt from taxes.
- Suppose you withdraw money from your HSA for non-medical or medical care expenses that do not meet the qualifying criteria before turning 65. In that case, you will be subject to paying federal income tax and a 20% tax penalty.
- If you withdraw your HSA money for non-medical expenses after turning 65, you will not be subject to the 20% tax penalty. However, you must still pay federal income tax on the amount withdrawn.
It is important to note that once you enroll in any part of Medicare, you should cease contributing to your HSA. You can withdraw funds from your HSA at any point to cover eligible medical expenses not covered by Medicare or Medicare Supplement Insurance (Medigap).
It is advisable to retain receipts for medical expenses that were paid for using HSA withdrawals. They must demonstrate that the HSA funds were solely utilized for paying or reimbursing qualified medical expenses. You are responsible for maintaining records of your health care costs and decisions in the event of an audit by the Internal Revenue Service (IRS).
What Expenses Do Health Savings Accounts Cover?
Withdrawals from your HSA are not subject to taxes if they are used for qualified medical expenses. Covered healthcare expenses include deductibles, dental care, vision care, prescription drugs, co-pays, psychiatric treatments, and other eligible health care expenses not covered by a health insurance plan.
Insurance premiums are not considered a qualified medical expense, with a few exceptions. These exceptions include premiums for Medicare or other health care coverage for individuals aged 65 or older, health care continuation coverage (COBRA) while receiving unemployment compensation, or long-term care insurance, subject to annually adjusted limits.
Qualified medical expenses do not include premiums for Medicare supplement or Medigap policies.
Using your HSA to pay for expenses that are not considered qualified medical expenses will result in the amount being subject to income tax and an additional 20% tax penalty unless you are 65 years of age or older. If that is the scenario, you only need to pay income tax on the withdrawn amount.
Should You get an HSA?
Before obtaining an HSA, consider whether you are interested in acquiring a high-deductible health plan, as it is a requirement. High Deductible Health Plans (HDHPs) offer lower monthly health insurance premiums, but require a higher deductible to be paid before insurance coverage begins.
As such, you will be required to bear higher out-of-pocket costs before your health insurance policy begins to provide coverage. Although an HSA can offer advantages, enrolling in a high-deductible plan may not be worthwhile solely to obtain one.
One advantage of having an HSA is the option to invest your funds. However, it’s important to note that the investment options may not be as versatile as those provided by conventional retirement plans, whether employer-sponsored or individual. HSAs can be valuable for increasing your savings. However, it’s important to note that more than their contribution limits may be needed to support you in retirement.
What is the Difference Between HSA and FSA?
A Flexible Spending Account (FSA) is a type of employee benefit that enables you to allocate funds on a pre-tax basis for specific health care and dependent care expenses. There are three types of Flexible Spending Accounts (FSAs) available:
- The Health Care FSA (HCFSA)
- The Limited Expense Health Care FSA (LEX HCFSA)
- And the Dependent Care FSA (DCFSA)
An HSA allows individuals with high-deductible health insurance plans to save pre-tax funds for health care expenses. Unused funds in the HSA at the end of the year will roll over to the next year.
An HSA provides more benefits than a health care FSA. It allows the account owner to invest their money and withdraw funds for non-medical purposes without penalty once they reach the age of 65. However, the withdrawn amount will be subject to income tax, similar to a traditional IRA. This means that many HSA owners use it as a secondary retirement account.
These accounts accrue interest and carry forward any remaining balance from one year to the next. You are entitled to keep the funds regardless of whether you switch plans, resign from Federal service, or retire. Withdrawals can be utilized for expenses other than medical ones. However, the amount will be liable to income tax, and if you are below the age of 65, you will also be charged an extra 10% tax penalty.
What are the Benefits and Drawbacks of an HSA?
The Benefits
- Tax savings is one of the most exciting benefits of HSA. Contributions made by employers and individuals through payroll deduction to an HSA are not considered taxable income for the employee. Contributions made by an individual directly to their HSA are fully tax deductible from their income. The earnings within the account are exempt from taxes. Contributions exceeding an HSA’s limit are subject to a 6% tax and cannot be deducted from taxes.
- If the funds from an HSA are utilized for qualified medical expenses as specified by the IRS, their distributions are exempt from taxes. Distributions for health care expenses covered under the HDHP plan are considered when determining whether the HDHP’s deductible has been fulfilled.
- In addition, it is possible to utilize the funds in your HSA to invest in stocks and other securities, which may result in greater returns in the long run.
The Drawbacks
- The primary disadvantage is that you must meet the eligibility criteria for an HDHP. Furthermore, having a high-deductible plan or lower insurance premiums or possessing enough affluence to cover the high deductibles and take advantage of the tax benefits is necessary.
- Individuals who choose to fund their HSAs through payroll deductions or direct contributions should have the financial capacity to set aside an adequate amount that can cover a significant portion of their HDHP deductibles. People who need more extra money to contribute to an HSA may find managing the high deductible amount challenging.
- HSAs have specific filing requirements related to contributions and particular rules governing withdrawals and distribution reporting. Additionally, maintaining records for HSAs can take time and effort.
What Happens to Unused Funds in a Health Savings Account?
After Year End
An HSA does not follow a “use it or lose it” policy for any remaining funds at the end of the year. Unused funds in the HSA at the end of the year will roll over to the next year. Instead of losing any unspent funds, the HSA money can stay there and increase in value without taxes until you decide to use it.
If You Change Jobs
Individuals with HSA accounts are considered the rightful owners of the account. They can carry the account with them if they leave their current job. If your new employer provides an HSA that suits your needs better, you can transfer the funds from your previous HSA to the new employer’s plan. If you still have your high-deductible health plan under COBRA, you can retain your HSA. COBRA (Consolidated Omnibus Budget Reconciliation Act) is a law that allows you to remain on your current healthcare plan after leaving your job. You can utilize your HSA funds to assist in paying for COBRA premiums.
When you switch jobs and your high deductible health care plan coverage ends, you are no longer eligible to contribute to the health plan. However, you can still use the funds in the plan for qualified medical expenses until the account balance is exhausted.
After Death
If any funds remain, the ownership of the account will be transferred to the beneficiary you have designated. How your account is handled can be significantly impacted by the beneficiary you select.
When the Beneficiary is Your Spouse
If your beneficiary is your spouse, your HSA will be transferred to them and become their HSA after your passing. Individuals can use the funds without being subject to taxes for healthcare-related expenses, regardless of whether they are enrolled in a qualifying high-deductible healthcare plan. Your spouse will also be subject to a 20% penalty tax if they withdraw money for non-health care-related expenses before age 65, similar to how you would be penalized. After your spouse turns 65, they can withdraw money without penalty. However, these distributions will be subject to income tax.
When the Beneficiary is not Your Spouse
The rules regarding beneficiaries differ when the designated beneficiary is not your spouse. Your HSA terminates upon your death, and the individual you have designated as your beneficiary will receive a distribution. The fair market value must be included in the beneficiary’s income, subjecting it to income tax.
This situation can be problematic: the non-spouse beneficiary may be pushed into a higher tax bracket by the amount of money received. If the deceased has any outstanding medical bills at the time of their death, the beneficiary can use the HSA funds to pay for those expenses within the same year. This will help in reducing the taxable amount for the beneficiary.
Key Takeaways
HSAs are considered one of the most beneficial tax-advantaged savings and investment options available within the U.S. Tax Code. These investments are commonly known as triple tax advantaged because:
- Contributions are exempt from taxation.
- Investing the money can result in tax-free growth.
- Withdrawals are tax-free, provided they are utilized for qualified health care expenses.
As individuals age, their healthcare expenses rise, especially when they reach retirement age. Starting an HSA early and letting it grow over a long period can significantly help secure your financial future.
