Health Savings Account (HSA): Become Financially Healthier
HSA is an extraordinary saving tool but its benefits are often overlooked and are rarely discussed as a part of a financial strategy for building personal wealth. This article will explain how HSA works and when contributing to an HSA makes sense.
What is an HSA?
Health Savings Account (HSA) is a savings plan that lets you set aside money to pay for qualified medical expenses. But HSA is not just a stash of cash for your health care costs - your health savings account can be an extraordinary tool for saving on taxes, growing your money, and boosting your retirement savings.
HSA is a tax-advantaged account, which means it provides tax benefits. Unlike most tax-advantaged accounts that provide benefits of either tax-exemption or tax-deferral, an HSA can be tax-deferred or tax-exempt with a unique triple tax benefit. Let's review the benefits and advantages of health savings accounts (HSAs) in detail.
Tax deferral is when paying taxes is delayed to some point in the future. With a tax-deferred account, you pay income taxes only when you withdraw money. A tax-exempt account is free from tax.
Tax Advantages of an HSA
HSA is designed to provide a triple tax break. When enrolment and spending criteria are met - deposits are tax-deductible, spending is tax-free, and the earned investment income is also tax-free.
HSA is not subject to federal income tax, and although state taxes are waived in most states, HSAs may be subject to state taxation. Consult with your tax advisor for your state's HSA regulation.
Am I Eligible to Participate?
HSAs are designed for people who choose an HSA-eligible high-deductible health plan (HDHP) as their health insurance. To contribute to an HSA and qualify for tax benefits, you must be covered by a high-deductible health plan (HDHP), not covered under a secondary health plan, not enrolled in Medicare, and not claimed as a dependent.
See IRS Publication 969 for all eligibility requirements: Publication 969.
What is an HSA-eligible High-Deductible Health Plan (HDHP)?
For 2022, the IRS defines HSA-eligible plans as high-deductible health plans (HDHPs) with a deductible of at least $1,400 for an individual and $2,800 for a family. These health plans must also have an annual out-of-pocket maximum spending amount of no more than $7,050 for an individual and $14,100 for a family.
See Publication 969 for IRS definition of HDHP: Publication 969.
How to Contribute Money to HSA?
If your employer offers a health savings account (HSA), you can opt-in for contributions from your paycheck before taxes are applied to your pay.
Your employer's contributions will be excluded from your income on your W-2, and you won't have to deduct them.
You can also open an HSA through a financial institution of your choice and contribute your after-tax dollars, then take a tax deduction when you file a tax return. Note that making contributions outside of payroll means you will not benefit from the FICA tax break - you will only receive the income tax break.
Money contributed to your HSA can be tax deductible only if you meet all eligibility criteria. Before opening and contributing to your HSA, ensure you adhere to all the eligibility criteria outlined by the IRS.
If you are familiar with 401k, you will notice similarities in the way how HSA works - the contributions are deducted from your paychecks before the tax is applied to your pay.
How Much Can I Contribute to My HSA?
The 2022 IRS contribution limits for an HSA are $3,650 for individuals and $7,300 for families. Your employer may also contribute to your HSA, and if your employer and you both contribute to an HSA, the total amount must be within the annual IRS contribution limits. The IRS adjusts the contribution limits every year. For each year you contribute to your HSA, make sure you check the current limits.
See Publication 969 for IRS contribution limits: Publication 969.
How Can I Spend My HSA Money?
The HSA is designed to pay for expenses not covered by your health insurance. But to be both tax-free and penalty-free, your HSA funds must be used only for qualified medical expenses. If you use your HSA funds before age 65 for non-qualified medical expenses, those withdrawals are subject to ordinary income tax and an additional 20% penalty, called a federal excise tax.
Starting at age 65, you can take penalty-free distributions from your HSA for any reason, but you will still need to pay ordinary income taxes for nonmedical expenses. Qualified medical expenses stay tax-free after age 65.
You can use the money not just for yourself, but also for your spouse, children, and dependents. Purchases can be made directly from your HSA account with your benefits card provided by the HSA custodian, check, or electronic bank-to-bank payment (ACH). You can also pay out-of-pocket and then reimburse yourself from your HSA.
Keep in mind that the IRS requires that you keep receipts for all your HSA spending in case you need to prove that you spent the money on qualified medical expenses.
What are Qualified Medical Expenses for HSA?
The IRS provides specific guidance for expenses that are covered by HSA. The list of allowed expenses is quite large and includes doctor visits, ambulance, prescriptions, psychiatric care, chiropractors, contact lenses, dental treatment, eyeglasses, X-rays, and much more. For the complete list of qualified medical expenses, check IRS Publication 502.
Expenses Not Eligible for HSA Reimbursement
Generally, you can't use your HSA to pay for expenses that don't directly prevent or treat illness. For example, nutritional supplements and weight loss programs not prescribed by a physician, cosmetic surgeries, and teeth bleaching are some examples of non-qualified medical expenses.
It is not always obvious which expenses qualify and which do not. Review the list of qualified expenses in IRS Publication 502 before you withdraw money from your health savings account.
See IRS Publication 502 for the complete list of qualified medical expenses: Publication 502.
Don't Confuse HSA with FSA
Unlike flexible spending accounts (FSAs), your HSA is not "use-it-or-lose-it". You don't have to spend all your money by the end of the year like with FSAs. HSA belongs to you, even if you find another job or retire. Your contributions can accumulate year after year and, if invested, continue to grow tax-deferred.
If you no longer have a high-deductible health plan, you will no longer be able to contribute to an HSA. But you still can use the money in your account tax-free for qualified medical expenses or keep them invested for potential growth.
How to Invest in Your HSA?
Even though you may not have many healthcare expenses today, the healthcare costs are likely to be higher in retirement. The possible tax advantages of an HSA make it a powerful long-term savings vehicle.
If you decide to use HSA to help pay for health care costs in retirement, you may want to protect your savings from the negative effects of inflation. If you let the money sit in your health savings account, over time, inflation will erode the value of your savings. To avoid this, you may choose to invest a part of all of your HSA funds and potentially grow your savings or at least offset the impact of inflation.
Investing your money through an HSA may help grow your health and retirement funds faster than by saving alone. All investment earnings in your HSA account grow tax-free, including dividends, interest, and capital gain.
How much to invest and where to invest depends on your situation, your financial goals, time horizon, and your risk tolerance. You also may be limited by the investment options that your HSA custodian offers. Like in your 401k plan, your investments may consist of individual stocks, mutual funds, bonds, and exchange-traded funds (ETFs) if the custodian offers these investment options. HSA custodians may offer a self-directed account for managing your own investments or an option with professional money management.
An HSA custodian is a financial institution approved by the Internal Revenue Service (IRS) to offer health savings accounts (HSAs).
Depending on your situation, you may want to set a cash cushion in your HSA to pay for short-term unanticipated medical bills and out-of-pocket maximum deductible limits before you have enough money in your HSA to begin investing.
The Downside of HSAs
The main downside of an HSA is that it requires a high-deductible health plan (HDHP). And although HDHPs charge lower premiums, which could mean big savings for you, they also have higher deductibles. A health insurance deductible is the out-of-pocket money you will need to pay before your insurance starts to cover your expenses.
And if you regularly receive medical treatment, paying deductibles and copays for office visits or prescriptions before your insurance kicks in may not be worth the benefits of an HSA, and paying higher premiums for a low-deductible health plan may save you more money. However, even if you are a high user of your health plan, a high-deductible plan and the benefits of HSA can still pay off.
You will need to figure out whether the savings in taxes and potential investment growth outweigh the benefits of more extensive coverage of the low-deductible health plan. You also need to ensure you have enough money to cover the deductible and copays in case of an accident or illness. If you can't afford the high deductible, a medical emergency can send you into a financial tailspin. Whether it makes sense depends on your health and financial situation, and you should crunch your numbers to compare both options.
How to Open an HSA?
See if your employer offers an HSA. Some companies make additional contributions to their employees' HSAs as a perk, and you may get some free money. If your employer doesn't offer HSA, or you prefer keeping your HSA separate from your employment, you can open a personal health savings account (HSA). Opening a health savings account is as easy as opening a regular saving or checking account. You just need to pick a financial institution that provides HSAs.
Some HSAs providers require a minimum balance to open an account or charge fees to open, maintain, or close the account. Before you decide where is the best place to open an HSA account, determine which provider has the lowest fees.
You can start your research by asking your health insurance company if they partner with HSA providers. Or you can check these companies that let you open a personal HSA:
Why a Health Savings Account (HSA) Is a Good Deal?
A health savings account can help you become financially healthier. Investing through your HSA may effortlessly boost your retirement savings when you are likely to have more health care needs. Even if you don't want to invest and will use the money in the near future, there is a potential to save significant amounts in federal and state income taxes (and FICA taxes if you contribute to the HSA on a pre-tax basis).
Health savings accounts (HSAs) are an excellent financial tool, but high deductible health plans (HDHPs) required to be eligible to contribute to HSAs will not work for everyone. Before making the switch, carefully assess your health condition and all of your medical expenses to see if HDHP coverage will make HSA worthwhile.
- Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans, https://www.irs.gov/pub/irs-pdf/p969.pdf
- Publication 502: Medical and Dental Expenses, https://www.irs.gov/pub/irs-pdf/p502.pdf