Even the best health insurance plans don’t cover every medical expense you could face.
Affordable Care Act-compliant health insurance plans cover anywhere from 60% to 90% of the policyholder’s total care costs on average. Plans that don’t comply with the Affordable Care Act, such as catastrophic plans and high-deductible health plans, cover even less.
Fortunately, your health insurance policy isn’t the only possible funding source for your health care expenses and related costs, such as copays and coinsurance. You can use two types of supplemental plans to cover these expenses: flexible spending accounts (FSAs) and health savings accounts (HSAs).
HSA vs. FSA: Key Differences
HSAs and health care FSAs have a lot in common, including potential tax advantages. But they’re not interchangeable. In fact, there are just as many notable differences as there are similarities.
A health savings account is like a bank account or investment account you can tap to pay for qualifying expenses. Like other tax-advantaged accounts, it has well-defined eligibility requirements, annual contribution limits, and withdrawal rules.
- Eligibility Requirements: You can only open an HSA if you also have a high deductible health plan (HDHP) and aren’t a dependent on someone else’s tax return or Medicare-eligible.
- Annual Contribution Limit: In 2022, you can contribute up to $3,650 per year to an individual HSA and $7,300 per year to an HSA tied to a family health plan. After age 55, you can make an additional $1,000 per year in catch-up contributions.
- Availability: You can get an HSA through your employer (if they offer one) or a private insurer.
- Account Type: The balance is held in an interest-bearing account or invested in equities.
- Employer Contribution: Employers can contribute to HSAs but aren’t required to. Combined employer and employee contributions can’t exceed $3,650 per year to an individual plan or $7,300 per year to a family plan in 2022.
- Tax Benefits: Your HSA contributions are pretax. They also grow tax-free, and you can withdraw them without paying income or capital gains taxes as long as you use them for an eligible purpose.
- Account Ownership: You own your HSA and the funds held in it.
- Portability: Because you own your HSA and its balance, you can take it with you when you change your job. However, if your HDHP coverage lapses, you can’t make additional contributions until you enroll in a new one.
- Contribution Amount Changes: You can change your HSA contributions at any time.
- Rollover Rules: You can roll over an old HSA into a new HSA if you change jobs or switch to or from a private HSA provider. The process is similar to rolling over a 401(k) — you call the old HSA sponsor, request a check, and use it to fund your new HSA.
- Withdrawal Rules: You can make tax-free withdrawals from your HSA at any time to cover eligible medical expenses. If you withdraw for nonmedical reasons, you pay income tax plus a 20% penalty on the withdrawn amount. After age 65, the withdrawal penalty goes away, and you can withdraw from your HSA for nonmedical expenses. But you pay tax on those withdrawals.
Advantages of HSAs
An HSA is a flexible account with the potential to grow over time. Thanks to its considerable benefits, many financial advisors recommend contributing to one if you have the choice.
- Higher Annual Contribution Limits. If you have one job, you can contribute more to your HSA than your health care FSA. And if your HDHP covers your entire family, you can contribute even more: $7,300 per year.
- Contributions Can Grow Tax-Free. Your HSA contributions have the potential to grow tax-free. How much they grow depends on what they’re invested in — balances held in a savings account grow slower than those invested in stocks and exchange-traded funds. Regardless, you don’t pay taxes on growth if you withdraw for eligible expenses.
- Easy to Change or Stop Contributions. You can increase, decrease, or stop your HSA contributions at any time. You don’t have to wait for an enrollment period.
- Unused Funds Carry Over Indefinitely. Your HSA isn’t use-it-or-lose-it. If you don’t incur any medical expenses in a particular year, no sweat — you can leave your HSA balance untouched without worrying about it disappearing.
- Not Tied to Your Employer. Your HSA is portable, meaning it’s not tied to your current employer. It remains yours after you leave your job, and you can roll it over into a new HSA if you wish. The only catch: You can’t make additional contributions without an active HDHP.
Disadvantages of HSAs
Your HSA isn’t pure upside. It has important restrictions and limitations that make it less useful than a taxable brokerage account or traditional savings account.
- Strict Eligibility Requirements. HSAs have stringent eligibility requirements. You must be enrolled in an HDHP to be eligible, and you can’t be Medicare-eligible or claimed as a dependent on someone else’s tax return.
- Stiff Penalty for Improper Use of Funds. Penalties for improper use of HSA funds are stiff: 20% off the top plus income tax at your regular rate. Think twice before raiding your HSA — at least before you turn 65 and the 20% penalty goes away.
A flexible spending account is more like a line of credit than a personal savings or investment account. It has different eligibility requirements, contribution limits, and withdrawal rules than an HSA as well.
- Eligibility Requirements: If your employer offers a health care FSA, you’re eligible to contribute to it, regardless of income or health insurance plan.
- Annual Contribution Limit: The annual contribution limit in 2022 is $2,850 per individual per employer. If you have two jobs and both employers have FSAs, you can contribute $5,700 per year between the two.
- Availability: You can only buy one from your employer, but the full amount of your expected contribution for the year is available immediately. You can use it at any time for qualifying medical expenses, even if you haven’t contributed the full amount from your paycheck yet.
- Account Type: The balance held in a non-interest-bearing account.
- Employer Contribution: Generally, IRS regulations cap employer contributions to health care FSA accounts at $500 per year. But your employer isn’t required to contribute anything.
- Tax Benefits: You make health care FSA contributions on a pretax basis. Your contributions don’t count toward your income tax liability.
- Account Ownership: Your employer owns your health care FSA account. You can’t move funds out of the account except to pay for eligible expenses.
- Portability: You can’t take your health care FSA balance with you if you change jobs. If you leave your employer before the end of the year, you forfeit any unused cash in your account unless you continue your health care FSA through COBRA.
- Contribution Amount Changes: You can only adjust your contribution amount during the annual open enrollment period or if there’s a change in your employment or family status.
- Rollover Rules: Unlike balances held in your 401(k) or other employer-sponsored retirement plan, you can’t roll over your health care FSA balance into a new account if you change jobs.
- Withdrawal Rules: Health care FSAs are use-it-or-lose-it. Generally, you must use your entire balance for the year by March 15 of the following year. Employers are allowed — but not required — to let you carry over up to $550 in prior-year balances into the next year.
Advantages of FSAs
Despite the name, your health care flexible spending account isn’t quite as flexible as your HSA. But it’s still super useful for covering miscellaneous expenses that might otherwise fall through the cracks — and land with a thud on your budget.
- Funds Are Available Immediately. You don’t have to wait for your FSA balance to accrue throughout the year. The full amount of your expected annual contribution is available right away.
- Few Eligibility Restrictions. If your employer offers a health care FSA, you’re eligible to contribute to it and reap the tax benefits. The only real eligibility restriction is employment with an organization that offers the FSA in the first place.
- Contribution Limits Are Per Account, Not Per Individual or Family. Most people don’t have two or three FSA-eligible jobs. But if you’re one of the lucky ones, you can contribute to each up to the per-account limit, potentially exceeding your total allowable HSA contributions.
Disadvantages of FSAs
Your health care FSA may require more attention than your HSA, and it’s a pain that it’s tied to your employer. Consider these drawbacks before contributing.
- Unused Funds Don’t Carry Over Indefinitely. Most of the funds you contribute this year will disappear on March 15 of next year if you don’t use them. You may be eligible to carry over up to $550 in contributions to the next year, but your employer doesn’t have to allow that.
- Can’t Take It With You if You Change Jobs. Your FSA isn’t portable. It’s your employer’s property, so you forfeit any unused funds in it if you leave your job.
- Restrictions on Contribution Changes. You can’t change your FSA contribution outside the open enrollment period. The only exception is if you qualify for special enrollment due to a life change, such as the birth of a child.
- Balances Don’t Grow or Earn Interest. Your FSA is more like a line of credit than a bank account. Its balance doesn’t earn interest, and you can’t invest it in any assets with growth potential.
The Verdict: Should You Choose an HSA or FSA?
HSAs and health care FSAs each have their own strengths and weaknesses. Which makes more sense for you?
You Should Choose an HSA If…
Many people find HSAs more flexible. An HSA is a better fit if:
- Your Medical Expenses Are Low Right Now. You don’t have to use the funds in your HSA on any particular timeline. That makes it a good fit if you don’t have significant medical expenses and don’t expect to for some time.
- You Expect to Leave Your Job Soon or Change Jobs Often. Your HSA is portable. You can take it with you if you leave your current employer.
- You Want a Secondary Source of Retirement Income. Because its balances grow tax-free and you can withdraw it without penalty after age 65, your HSA is a sort of stealth retirement account. A health FSA can’t say the same.
- You Want the Flexibility to Change Your Contributions on the Fly. You can change or stop your HSA contributions at any point during the year. You don’t have to wait for an open or special enrollment period.
You Should Choose an FSA If…
As flexible as HSAs seem, health FSAs are a better option for some people. An FSA is a better fit if:
- You Can Easily Use Your Funds During the Contribution Year. If you expect to have no trouble using your contributions by March 15 of next year, a health FSA can significantly reduce your out-of-pocket medical expenses.
- You’re Not Eligible for an HSA for Any Reason. If you’re not enrolled in an HDHP, you’re not eligible for an HSA. There are other reasons you might not be HSA-eligible too. But if your employer offers a health FSA, you’re almost certainly eligible for it.
- You Don’t Want to Wait for Your Contributions to Accrue. The full amount of your expected FSA contribution is available at the beginning of the year. That’s useful if you expect a significant medical expense during the first or second quarter.
HSAs and health care FSAs have distinct strengths, weaknesses, and use cases. But if you’re eligible for both and have the budgetary breathing room to do so, there’s no reason not to contribute to both.
While you’re at it, review your other tax-advantaged account contributions and ensure you’re maximizing your money’s potential. Upping your contribution to your 401(k) or traditional IRA could reduce your current-year income tax burden and help you take full advantage of the power of compounding. And you’ll be less tempted to raid those accounts if you have your HSA and FSA working for you too.