What is a Health Savings Account?

A Health Savings Account is similar to a personal savings account because the money you deposit is yours. You control the money, the funds never expire, and you can withdraw from the account at any time without federal tax liability or penalty — as long as you use the money to pay for qualified medical expenses. 

Because the money you save using an HSA is not subject to federal income tax at the time of deposit, you gain two benefits at once: healthcare savings and tax savings. You can also earn tax-free interest on the money in your HSA and may even be able to invest some of it so that it continues to grow tax-free. 

To put it more simply: an HSA allows you to deposit money pre-tax, grow it tax-free, and withdraw it tax-free, provided you use it to pay for qualified medical expenses. 

What’s more, an HSA can also make an exceptional vehicle to save for retirement. If you are 65 or older, you may withdraw from your HSA without penalty (although the IRS will tax you on the funds at your standard rate if you use them for general expenses; qualified medical expenses remain tax-free for seniors). 

That means you can use your HSA savings for general expenses, not just eligible medical costs. Arguably, this makes Health Savings Accounts better for retirement savings than 401(k) or IRA accounts, which get taxed either at contribution or withdrawal, depending on the type. 

That’s the good news. Here’s the bad: You can only contribute to an HSA if you have coverage from a High-Deductible Health Plan (HDHP)

What is a High-Deductible Health Plan (HDHP)?

A High-Deductible Health Plan is just what it sounds like: a plan with a higher deductible than a traditional health insurance plan. 

High-deductible plans typically also offer a lower monthly premium, which can benefit participants who do not expect many medical expenses. In the event that an HDHP participant does incur healthcare costs, however, the participant would shoulder a larger share of the expense themselves before the insurance company steps in.

Health Savings Accounts are designed to help with this type of situation. HSAs can alleviate the burden of paying healthcare costs when your plan has a higher deductible by providing a tax-advantaged way to save for such expenses

As such, only those covered by a High-Deductible Health Plan are eligible to contribute to a Health Savings Account. 

Furthermore, to be eligible for an HSA, you must:

  • Not by covered under any health plan that is not a qualified HDHP (with some limited exceptions).
  • Not be enrolled in Medicare.
  • Not be claimed as a dependent on another individual’s tax return.

How does an HSA work?

If you are already covered by an HDHP, enrolling in a Health Savings Account is easy. Many employers offer them as an option along with an HDHP, but you do not need to be an employee to qualify for an HSA. You can start one independently through a bank or financial institution, as long as you are under 65 and covered by a High-Deductible Health Plan. 

If you do not already have an HDHP, you’ll need to find one that is HSA-eligible. This is easy to do on HealthCare.gov, where you can identify HSA-eligible HDHPs by a flag on the plan cards. You can also filter to see only HSA-eligible plans as you shop. 

Next, you’ll need to select an HSA financial institution. Your health insurance company may already partner with an HSA provider. If not, your bank may offer an option, or you can research and compare providers online

When choosing an HSA, keep in mind that some may have fees, such as opening or closing an account, and banking options, services, and features may differ by provider. 

When planning for your HSA savings, you should also know that the IRS sets annual contribution limits. For the 2022 tax year, you will not be able to deposit more than $3,650 for an individual or $7,300 for a family. Participants aged 55 or older may deposit an extra $1,000 per year as a “catch-up contribution.” 

Because the funds you add to your HSA never expire but rather roll over year from year to year, so you may want to consider contributing the maximum allowable amount each year. If you can afford to do so and consider the impact on your broader finances, there are few drawbacks to maxing out your contribution. After all, the money is yours, and the more you contribute, the more you can benefit from the tax advantages. 

If you have enrolled in your HSA through your employer, your employer may also contribute to your account. An eligible family member can also deposit funds. Once their contribution enters your account, the money becomes yours — however, the same contribution limits apply to the account, even if your employer or family member deposits some of the money.

Finally, there is a wide range of medical expenses that you can pay for with your HSA. This includes many not often covered by health insurance plans, such as deductibles, co-insurance, prescriptions, dental, vision, and more. 

The IRS provides more detail on qualifying medical expenses in Publication 502.

What are the pros and cons of a Health Savings Account?

Saving with an HSA comes with plenty of advantages. As I’ve already discussed, they can help keep your premiums affordable by providing peace of mind with a higher-deductible plan. They offer tax exemptions and benefits and make an excellent vehicle for retirement savings. 

Other advantages include:

  • Flexibility
  • Portability (you can change trustees once every twelve months)
  • Security (bank and credit union HSAs are insured up to $250,000)

There are disadvantages as well. 

For example, you never know when you might get sick. This can make it difficult to budget for your medical expenses using an HSA accurately. Should the worst happen and you find yourself hit with many medical expenses, your HSA may not be enough to offset your high deductible. In this case, you could end up responsible for a lot of out-of-pocket costs. 

Additionally, the benefits of an HSA are somewhat dependent on how much you can contribute each year. Meanwhile, the requirement that the funds be used for qualified medical expenses only to remain tax-exempt means you will have to be sure of your financial planning before you decide to use an HSA.  

Finally, because an HSA can be an effective savings account, it can be tempting to forego healthcare you might need because you are reluctant to withdraw funds. 

You will need to weigh these pros and cons carefully before deciding whether or not a Health Savings Account is right for you. Seeking the guidance of an experienced tax professional is an excellent first step. 

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