Even the best health insurance plans don’t cover every medical expense (and health care-adjacent expense) you or a loved one on your plan could incur during your working life. =
Depending on their “metal” tier (bronze, silver, gold, or platinum), health insurance plans that comply with the Affordable Care Act (ACA) cover anywhere from 60% to 90% of the policyholder’s total care costs on average. Plans that don’t comply with the ACA, such as catastrophic health insurance plans and high-deductible health plans (HDHPs), cover even less.
Fortunately, health care consumers can turn to two similar but distinct supplemental plans — health care flexible spending accounts (FSAs) and health savings accounts (HSAs) — to cover medical and medical-related expenses not covered by insurance, such as copays, coinsurance, and dental care.
But it’s essential you understand the differences between these two types of tax-advantaged accounts and determine which is best for your needs.
What Are Health Care FSA & HSA Plans?
Health care FSA and HSA plans are tax-advantaged accounts. You can use their funds to pay for qualifying medical expenses.
Most HSAs and all health care FSAs are employer-sponsored, with employees (and often employers as well, though that isn’t required) contributing to their plans via payroll deductions every pay period.
In the 2020 tax year, IRS regulations cap annual HSA contributions at $3,550 for most individuals ($4,550 for individuals over age 50) and $7,100 for families. The IRS caps health care FSA contributions at $2,750 for the 2020 tax year.
For both HSAs and health care FSAs, paycheck contributions come from before-tax income and therefore aren’t subject to federal income, Social Security, and Medicare taxes. Withdrawals are tax-free when used for qualifying medical expenses. Funds held in HSAs also grow tax-free.
Depending on the terms of the plan and your personal risk tolerance, you can elect to invest HSA contributions in market-traded securities such as stocks and exchange-traded funds, Federal Deposit Insurance Corporation-insured instruments such as money market accounts, or some combination of both.
By contrast, a health care FSA is more like a line of credit than a personal savings or investment account. You can’t invest health care FSA contributions in the market, so balances don’t grow over time.
Some employers offer both HSA and health care FSA plans as part of their employee benefits packages. Employers aren’t required to contribute to their employees’ plans but can if they want.
Health care FSAs are only available through employers. But some financial institutions offer individual (nonemployer) HSAs.
Nonemployer HSA contributions occur on a post-tax basis and are then tax-deductible for federal income tax purposes in the contribution year. Compared with an employer HSA, that results in a marginally less attractive tax benefit.
But nonemployer HSAs give account holders the freedom to choose their own account management provider, potentially resulting in lower fees or better investment options. For example, Lively, a popular nonemployer HSA provider, is free for individuals and families.
Qualifying Expenses & Withdrawal Rules
Health care FSA and HSA account holders and their spouses and dependents can use the funds in the plan to pay for qualifying medical expenses:
- Qualifying prescriptions, including common types of medication like antidiarrheals, antifungals, and anti-inflammatories
- Copays or deductibles
- Coinsurance costs
- Certain medical equipment, including common types like blood glucose monitors, blood pressure monitors, and snore guards
When used for qualifying expenses, health care FSA and HSA withdrawals (sometimes called distributions) are tax-free.
If you withdraw money from your HSA for unqualified expenses before the age of 65, you incur a 20% penalty and pay taxes on the amount.
After 65, you can withdraw your money without incurring a penalty, but you’ll still owe income taxes on the amount you withdraw if you don’t use it for qualified medical expenses.
Health care FSA withdrawals for unqualified expenses are not taxed or penalized by the federal government. But they’re liable to be denied by the plan administrator (or require you to repay them if they didn’t discover the mistake right away).
Health Care Flexible Spending Accounts
Employers can offer health care FSAs as part of a benefits package — you can’t get one on your own. The plans limit the amount you can contribute, and you must use most or all of it by the end of the contribution year.
Some health care FSAs have a “carryover” option that allows account holders to roll over up to $500 in contributions to the subsequent plan year.
You’ll lose any funds not used by the end of the contribution year or carried over to the subsequent year. So it’s critical you try to use the funds in your account before the year’s end.
It seems relatively simple, but there are several other things you should know about how a health care FSA works.
- Health care FSAs are distinct from dependent care FSAs, which help offset account holders’ eligible child care expenses and elder care expenses. You’re free to open and contribute to both types of FSAs simultaneously.
- The full amount of your expected contribution for the year is available immediately, and you can use it at any time for qualifying medical expenses, even if you haven’t contributed the full amount from your paycheck yet.
- You can only adjust your contribution amount during the annual open enrollment or if there’s a change in your employment or family status.
- IRS regulations cap employer contributions to health care FSA accounts at $500 per year.
- You can’t use health care FSA funds to purchase over-the-counter medications.
- Unlike contributions to employer-sponsored retirement plans, such as 401(k) plans, health care FSA contributions don’t have a vesting period. They’re yours to use immediately unless you lose your job before the end of the year, in which case you’ll forfeit any unused cash in your account unless you continue your health care FSA through COBRA.
Health care FSAs are best for managing recurring and near-term health care expenses not covered by insurance.
Health Savings Accounts
HSAs are only available to people who have a high-deductible health plan (HDHP). You can’t open an HSA if any of the following conditions apply:
- You have any other type of health insurance coverage other than an HDHP
- You’re eligible for Medicare
- You have no health insurance coverage at all
- Someone else can claim you as a dependent on their tax return
But once your account is open, you can use the funds held in it for qualified medical expenses at any time, even if you cancel or lose your health insurance coverage.
HSAs are slightly more complicated than health care FSAs. Remember these important facts about HSAs when determining the best fit for your needs.
- If you quit or lose your job, your HSA balance goes with you, including your employer’s contributions. However, you can’t make new contributions to the account unless you have a qualifying HDHP — either by continuing coverage under your employer’s old HDHP via COBRA or purchasing a new HDHP on the individual health insurance marketplace.
- You can change how much you contribute to your HSA account at any time during the year.
- Money you don’t use for medical expenses in a given year carries over into subsequent years without limits.
- You can use an HSA in conjunction with a limited-purpose health reimbursement account (HRA) to cover vision and dental expenses. As with health care FSAs, funds held in limited-purpose HRAs generally don’t carry over from year to year.
- You don’t need to withdraw HSA funds to cover a qualifying expense in the year you incur it. As long as you save your receipts and don’t claim a federal income tax deduction on the expense, you can leave your money in the account and allow it to grow tax-free, then withdraw it when you’re ready, no matter how much time has passed.
HSAs are best for planning for longer-term health care expenses and preserving the option to make general use withdrawals.
Both a health care FSA and an HSA can help you manage your out-of-pocket medical expenses.
Generally, a health care FSA makes more sense for managing routine medical expenses, such as vision and dental care, that aren’t covered by your health insurance plan. Because health care FSA balances generally don’t carry over from year to year, they’re not appropriate for managing longer-term needs.
HSAs are appropriate for long-term medical expense management. Essentially, they function as medical emergency funds that quietly grow until you incur a major medical expense or run into financial trouble. For those fortunate enough to avoid either during their working lives, HSAs transform into general-purpose slush funds — reinforcement for their owners’ nest eggs.