Health savings accounts (HSAs) are like personal savings accounts, but the money in them is used to pay for health care expenses. You — not your employer or insurance company — own and control the money in your HSA.
One benefit of an HSA is that the money you deposit into the account is not taxed. To be eligible to open an HSA, you must have a special type of health insurance called a high-deductible plan.
Who Can Open a Health Savings Account?
According to federal guidelines, you can open and contribute to a HSA if you:
- Are covered under a qualifying high-deductible health plan which meets the minimum deductible and the maximum out of pocket threshold for the year
- Are not covered by any other medical plan, such as that for a spouse
- Are not enrolled in Medicare
- Are not enrolled in TRICARE or TRICARE for Life
- Are not claimed as a dependent on someone else’s tax return
- Are not covered by medical benefits from the Veterans Administration
- Do not have any disqualifying alternative medical savings accounts, like a Flexible Spending Account or Health Reimbursement Account
How does an HSA work?
Grant-Smith explains that they “offer triple tax benefits.” By that she means:
- You get a tax deduction when you put money in your account
- The earnings in your account grow tax-free
- The distribution—aka, the money you take out of your account—is not taxed, as long as you are reimbursing yourself for a qualified medical expense. (If you take money out of your HSA for non-medical expenses, you’ll have to pay taxes and a 20% penalty on it. If you are over 65 or become disabled, you won’t be assessed the penalty, but you will still pay taxes as if it is regular income.)
What are the advantages of a health savings account?
There are many advantages to using a health savings account, including:
- Typically there is no initial deposit required to open an account: HSAs are portable and you can change trustees once every 12 months. Bank and credit union HSA accounts are insured up to $250,000.
- Your employer or other eligible family member can contribute to your HSA although the maximum contribution limits still apply. Employer contributions are not counted as income and you can claim a tax deduction for contributions you make and for contributions a family member makes.
- Funds can be used to pay for qualified medical expenses for a spouse and dependent children even if they are not covered under your health plan.
- After retirement, funds can be used to pay for Medicare or Medicare Advantage plan premiums (but not Medigap policies).
- After age 65, withdrawal of funds for non-medical uses avoids the 20 percent penalty although these withdrawals are considered as taxable income. Some people have used their HSA nest egg to purchase investment property.
- Funds can be transferred out of your investment portion of your account (typically mutual funds or stocks) as needed to pay for approved medical expenses.
- For those not working, you can still contribute to your HSA account. Although these contributions won’t be pre-tax, they can be deducted on your tax return.
What are the disadvantages of a health savings account?
It’s important to consider the potential disadvantages of using a health savings account.
- Withdrawal of funds for non-medical purposes prior to age 65 are considered taxable income and a 20 percent penalty is also assessed by the IRS.
- Some big box stores and other merchants do not accept HSA cards and you will have to obtain reimbursement from your HSA trustee.
- If you are claimed as a dependent on someone else’s tax return, you are not eligible for an HSA.
- Expenses can be audited by the IRS so you will have to keep receipts for all purchases.
- Interest rates on HSA accounts are low and some trustees charge a monthly fee if your balance drops below a certain threshold.
- If you don’t stop contributing to your HSA six months before you apply for social security benefits, tax penalties may apply.
- After an individual has attained age 65 (Medicare eligibility age), additional contributions (including catch up contributions) can no longer be made, even if still employed.
- Minimum balance requirements may apply before you can invest; investment options may be limited and investments are not insured.
Other alternatives to consider
If you have an HDHP, and that plan is offered by your employer, HSAs aren’t necessarily the only option you have for setting aside tax-free money for health expenses. You might also want to consider a health reimbursement account (HRA) or a healthcare flexible spending account (FSA).
An HRA is a type of health spending account that your employer might offer in your benefits package. Only your employer can contribute to the account, and the employer owns it. The money that your employer contributes to your HRA is not considered income for tax purposes. YourE controls almost everything about the HRA, including which expenses it covers and whether or not to allow funds to roll over into the next year.
A healthcare FSA is another type of health spending account, usually associated with plans with lower deductibles. Like HRAs, these can only be offered by employers. As such, your employer owns these accounts too. However, both you and your employer are allowed to contribute to an FSA. One of the main drawbacks is that FSAs are “use it or lose it.” If you don’t use all of your FSA money by the end of the year (or until the following April on some plans), your employer is allowed to keep the remainder.