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What Is a Health Savings Account (HSA)?

Health care costs continue to rise faster than both wages and inflation. In 2021, the Kaiser Family Foundation reported that the average health insurance premium for families with employer-sponsored health insurance reached a dizzying $22,221 per year.

That figure should give families without employer coverage even more shivers.

As premiums spiral higher out of reach for many American families, more turn to lower-premium, high-deductible health plans. And in a rare welcome move, Congress helped them out by creating the health savings account, or HSA.

What Is a Health Savings Account (HSA)?

Think of HSAs like individual retirement accounts (IRAs) for medical expenses.

To cover increasingly high deductibles, Congress allows you to set aside money tax-free in a health savings account. You can tap your HSA to pay medical costs until you reach the deductible threshold, at which point the insurance coverage kicks in to cover additional expenses.

The HSA was created under Title XII of the 2003 Medicare Prescription Drug, Improvement and Modernization Act. Modeled after an earlier successful IRS pilot program, the tax benefits encourage you to set aside enough money to cover your medical bills before your health insurance kicks in at your deductible.

How an HSA Works

Like an IRA, you contribute money to your HSA account, and you get to deduct the contribution from your taxable income. But you also get the tax benefits of a Roth IRA: the money grows and compounds tax-free, and you pay no taxes on withdrawals either. 

You can withdraw the money at any time, but withdrawals must go toward qualified medical expenses. More on those shortly.

The idea is simple: you get a tax break for setting aside money for health care costs. It works like an emergency fund specifically for medical expenses. 

Health savings accounts come in two broad types, checking-style accounts and investment accounts. The former work like checking accounts, as a cash deposit account insured by FDIC, which you can tap to pay for expenses by writing checks or swiping a debit card. Investment accounts work like brokerage accounts, where you pick and choose investments. 

You can open both, to split your money between them. Many of the best HSA providers offer both types of accounts. 

Who Qualifies for an HSA?

In order to qualify for an HSA, you must have a high-deductible health plan (HDHP)

Higher deductibles translate to a lower premium for insurance coverage because the insurance company is less likely to pay out any claims in any given year. Like all insurance, lower risk for the insurer means lower premiums for the customer.

Anyone with a high-deductible health plan can open an HSA, regardless of whether you, your spouse, or your employer pays the premium. That means that the self-employed and other people without employer health coverage can buy an HDHP and open an HSA to go with it.

Beware that while most health insurers offer high-deductible policies, not all such policies qualify to pair with HSAs. The insurer must agree to federal reporting requirements and comply with the state’s insurance laws, as well as meet the necessary requirements.

What Can I Use My HSA For? (What Is HSA-Eligible?)

You can only withdraw money from your HSA to cover health-related expenses. Fortunately, that’s a huge umbrella. 

It includes not just doctor’s appointment copays and medications but also eyeglasses, contact lenses, dental care, fertility costs, birth control, bandages, hospice and long-term care, psychotherapy, and any other conceivably health-related expenses. See IRS Publication 502 for the complete list of qualified medical and dental expenses.

If you spend your HSA funds on non-qualified expenses, the IRS hits you with a nasty 20% penalty, plus taxes. Account holders age 65 and over avoid the penalty, but still have to pay taxes on withdrawals. 

Limitations and Rules

Like every tax-advantaged account, HSAs come with their fair share of rules and limitations. 

Make sure you understand all of these limits before choosing a health insurance policy and opening an HSA. 

Contribution Limits

You can deduct contributions up to $3,600 for individuals or $7,200 for families with high-deductible health plans in 2021. In 2022, those limits rise to $3,650 for individuals or $7,300 for families.

Taxpayers over age 55 can contribute an extra $1,000 in catch-up contributions, similar to IRAs.

Note that if your employer contributes to your HSA as a job benefit, the limits above represent combined total contributions. You can’t each contribute $3,600 to an individual HSA.

Minimum Deductible

As the name suggests, a high-deductible health plan must have a high deductible before kicking in to cover medical expenses. In 2021 and 2022, the minimum deductible required is $1,400 for an individual or $2,800 for a family.

The IRS places no limit on the fund balance, which can accumulate over your lifetime.

Out-of-Pocket Maximum

Beyond a minimum deductible, HDHPs must also limit the maximum out-of-pocket liability that you face as a policyholder. 

In 2021, that maximum annual liability is limited to $7,000 for individuals and $14,000 for families. Those limits rise to $7,050 and $14,100 respectively in 2022. 

Advantages of HSAs

Health savings accounts come with a slew of benefits. In fact, they offer the best tax advantages of any tax-sheltered account. But the perks don’t end there.

1. Tax-Free Contributions

Similar to traditional IRAs, contributions to your HSA are deductible from your taxable income. That means you get a tax break today, creating an immediate return on your contributions.

You can deduct the contribution even if you take the standard deduction. 

2. Tax-Free Growth & Withdrawals

With retirement accounts, investors have to choose between a tax break now (as with traditional IRAs) or tax break later when they withdraw funds (as with Roth IRAs).

With HSAs, you get both — no tradeoff required. These accounts offer triple tax protection: you take the tax deduction this year, the money grows and compounds tax-free, and you can withdraw it tax-free at any time to pay for medical expenses. This means you don’t have to wait until you’re 59 ½ to access the funds, like you do with an IRA.

​​3. Tax-Deferred Withdrawals for Nonmedical Expenses in Retirement

After age 65, withdrawals for nonmedical expenses are taxed at ordinary tax rates without the 20% penalty.

Again, HSAs follow rules similar to those of traditional IRAs. If you pull money out in retirement for nonmedical expenses, you pay no more in taxes than you would with a traditional IRA.

4. Portability

Unlike many employment benefits, you own an HSA. It remains intact whether you remain with the same employer, replace account administrators, alter your investment strategy or choices, or change your insurer. Provided your new policy continues to qualify as a high-deductible health insurance policy, that is.

If the account still contains funds upon your death, ownership transfers to your named beneficiary or is distributed as part of your estate. If you’re married, the HSA funds simply flow to your surviving spouse’s HSA account. If you have no surviving spouse, the untaxed growth is taxed at the heir’s normal income tax rate.

5. Flexibility

Like in an IRA account, you get to invest in whatever you want.

Eligible investments in an HSA include stocks, exchange-traded funds (ETFs), real estate investment trusts (REITs), bonds, mutual funds, savings accounts, and other investments depending upon the options allowed by your HSA administrator of choice. In addition, each HSA administrator typically provides a range of account services, including special checking accounts, debit cards, and electronic bill payment.

With that kind of flexibility, it’s no wonder some savvy investors use their HSA for more than just an extra checking account for health expenses.

6. Others Can Contribute

Your employer can contribute to your HSA as an additional benefit of employment. 

But other family members can also contribute to your HSA to help you cover medical costs. If your parents or siblings want to help you out financially, without the impersonal or awkward feeling of handing you a check, they can deposit money in your HSA and know it will be spent well. 

You still get the tax deduction, even though someone else contributed to your account. 

7. Annual Rollover

There’s no time limit requiring you to use your HSA funds in a single year. If you don’t touch your HSA one year, your funds in it simply keep growing tax-free. 

You pull out money when you need it, not based on the government’s schedule.

8. Your HSA Can Serve as a Second Retirement Account

Spoiler alert: You’re going to have a lot of health-related expenses in retirement. One report by Fidelity found that the average couple spends $285,000 on health care after the age of 65.

High medical expenses will be a reality when you retire. So why not invest money for them now, tax-free?

The tax benefits of an HSA are better than those of an IRA or 401(k). You lower your tax bill this year with contributions, and you avoid paying taxes later on the withdrawals. Some investors contribute first to their HSA, then contribute to their IRA only once they’ve reached the HSA annual contribution limit.

9. Can Use as an Emergency Fund

Another creative approach to using your HSA is as an additional layer of your emergency fund. Say you have $2,000 in your regular savings account, $10,000 in your HSA, and a deductible of $3,000 for your health insurance. You contribute part of every paycheck to your HSA as a tax-sheltered, growth-oriented investment account. 

Imagine that in March, you face a $1,000 medical bill. You pay it out of your normal savings account, leaving your HSA untouched and invested to grow tax-free, hoping you don’t get hit with any other medical expenses that year. But in October, you face another $2,000 medical bill.

You can, of course, tap into your HSA for that October bill. You can also retroactively withdraw money to pay for your March bill too, if you like. Because you can withdraw funds at any time throughout the calendar year for health expense reimbursement, it gives you the flexibility to try to cover your health expenses with cash and later decide if you want to tap into your HSA for them.

Disadvantages of HSAs

Health savings accounts come with their own risks and downsides. Make sure you fully understand them as you explore your health care options.

1. High-Deductible Plan Required

Not everyone wants a high-deductible health care plan — even if they would love the tax benefits of an HSA. 

But you can’t contribute to an HSA without an HDHP, so families who prefer a lower-deductible plan are out of luck.

2. Taxes & Penalties on Nonqualified Expenses

Like all tax-advantaged accounts, HSAs have a specific purpose and rules. Break those rules, and you feel the wrath of the IRS. 

For Americans under 65, the penalty for using HSA funds for non-qualified expenses is particularly sharp at 20%. Contrast that against the early withdrawal penalty for IRA funds, which is only half that at 10%. 

3. You Must Keep Expense Records

Your HSA provider issues a Form 1099-SA each year to report your withdrawals to the IRS. If you’re audited, you better be able to produce receipts for your qualified medical expenses, adding up to at least the total you withdrew from your HSA. 

Otherwise the IRS drops that 20% penalty hammer on you, plus back taxes. Cue the pain and suffering. 

4. Risk of Deferring Medical Treatments

When you can invest money to compound tax-free, you want to leave it invested. That goes for when the market performs well for you, as no one wants to give up future gains. And it applies just as much when the market plummets — you don’t want to sell low and realize your losses.

That reluctance to pull money out of their investments leads some to avoid tapping their HSA and avoid medical expenses in general. But preventative medicine keeps us healthy and detects potentially serious medical problems early. 

Be careful not to skimp on regular checkups and other preventative care simply to avoid draining funds from your tax-free HSA. 

Frequently Asked Questions (FAQs)

Have questions about the minutiae of how HSAs work? No sweat. Below are answers to some of the most common questions about HSAs.

What’s the Difference Between an HSA vs. an FSA?

Health care flexible spending accounts, or FSAs, share some common features with HSAs. They’re an employee benefit account, designed to help workers cover out-of-pocket medical expenses. 

Funds in FSAs don’t typically carry over from one year to another however, although some FSAs come with a carryover option that allows you to roll over up to $500. FSAs are more of a “use it or lose it” benefit whereas HSAs are tax-sheltered accounts that you own and can hold onto through the years.

For full details, read up on the differences between HSAs and FSAs.

What Happens if I Overcontribute to My HSA?

The consequences of contributing too much to your HSA in a year depends on whether you catch it before or after you file your federal income tax return. 

If you catch it before filing, you can simply withdraw the overage, plus any earnings on it — no harm, no foul. After you file your return, however, the IRS hits you with a 6% penalty for each year the overage remains in your HSA. 

What Happens to Unused HSA Funds?

Funds in your HSA remain in place, and continue to earn interest or returns, until you withdraw them. 

You own the funds completely. They don’t disappear at the end of the calendar year — there’s no “use it or lose it” clause. 

What Happens If I Contribute to an HSA While on Medicare?

Medicare doesn’t qualify as a high-deductible health care plan. Therefore, you can’t contribute to an HSA once you enroll in Medicare. If you do, the IRS hits you with a penalty plus taxes.

You can, however, continue to spend down your HSA balance once you enroll in Medicare. In fact, you can use HSA funds to cover some Medicare costs. 

What Happens to My HSA When I Retire?

What does retiring do to your HSA account? Nothing — your account continues to belong to you. However Medicare enrollment does prevent you from making new HSA contributions, as outlined above.

What Happens to My HSA When I Turn 65?

Assuming you switch to Medicare coverage — which most people must at 65 — you can no longer contribute to your HSA. But you can keep withdrawing and using the funds you’ve accumulated there. 

At 65, the IRS no longer hits you with a penalty for spending withdrawals on nonqualified expenses. However, money you withdraw from the account for nonmedical expenses is taxed as ordinary income in this case. 

What Happens to My HSA When I Change Insurance?

If you change to another high-deductible health plan, you can keep contributing. 

If you switch to a health insurance policy incompatible with HSAs, you can no longer contribute. But as with Medicare, you can keep withdrawing funds from your HSA for qualified health expenses.

What Is an Unrestricted HSA Card?

Some checking account-style HSAs issue debit cards to account holders. Like other debit cards, the bank typically puts a daily limit on card purchases and withdrawals. 

The HSA provider may put other restrictions on the debit card as well, such as ATM withdrawals or types of retailers where it can be swiped.

Can I Use My HSA for Someone Else?

You can only withdraw funds penalty- and tax-free from your HSA to cover health care expenses for yourself, your spouse, or your dependents. 

Otherwise expect a rap-tap-tap at the door from the IRS. 

What Happens to My HSA When I Die?

If your spouse survives you, your HSA funds roll over to their HSA for a simple, tax-free transfer.

You can also name a non-spouse beneficiary on your account. In this case, they inherit the funds and pay taxes on the market value, although they can withdraw money tax-free for qualified medical expenses for up to 12 months after inheriting it.

Otherwise your HSA becomes part of your estate, to be distributed according to your estate plan

Final Word

As people age, the proportion of their income devoted to maintaining health increases. Rare is the person who lives a long life with no significant medical expenses.

Establishing an HSA allows you to save and invest for inevitable medical costs while doubling as a retirement account for other purposes when you’re older. HSAs combine flexibility with unique tax benefits not available in any other account type.

If they have a downside, it’s that many people are reluctant to seek preventative care when they have to pay for it out of pocket. Resist the urge to save a few dollars today at the expense of your health tomorrow. Even from a purely financial perspective, preventative care saves you thousands of dollars in lifetime health expenses by catching problems early before they require more expensive and invasive treatments.

G. Brian Davis is a real estate investor, personal finance writer, and travel addict mildly obsessed with FIRE. He spends nine months of the year in Abu Dhabi, and splits the rest of the year between his hometown of Baltimore and traveling the world.

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