A health savings account (HSA) is an account for you to contribute pre-taxed dollars to later pay for qualified medical expenses. By contributing to an HSA, you can pay for established medical, dental, and mental health services. It can be used to pay for deductibles, copayments, coinsurance, or a variety of other expenses.

It may be beneficial to set up an HSA on your own if your employer or insurance plan does not already provide one. An HSA can help decrease out-of-pocket costs for high-deductible health plans, prepare you for retirement, keep you healthy, and give you peace of mind that you will be able to pay for future health expenses. To understand how to get the most out of your HSA, you’ll have to know how it works and its advantages and disadvantages.

How Does an HSA Work?

If you are considering an HSA, you must first be enrolled in a High Deductible Health Plan (HDHP). An HDHP is an insurance plan that generally comes with a lower monthly premium. But, as the name suggests, you’ll have to pay more out-of-pocket (your deductible) before your benefits kick in and your insurer starts paying for health care costs. 

A properly funded HSA will allow you to pay for this high deductible and other qualified medical expenses out of pocket. HSA contributions are treated as either tax-deductible (meaning you can deduct them from your total taxable income for the year when filing), or pre-tax (meaning your contributions are deducted from payroll and not counted as part of your taxable income for the year). This means putting money into an HSA can effectively lower your taxable income for the year, potentially saving you additional money. Additionally, annual rollovers provided by your HSA means that your money will extend into the new year if you haven’t spent it yet.

Additional HSA account features might be similar to certain types of investment accounts and may provide you with opportunities such as interest earned on cash balances, receipt and expense tracking (which will come in handy for tax purposes), services allowing for easy contribution and transfer of money, and much more.

Qualified expenses that you can use an HSA to pay for are a subject of ongoing advisement by the IRS. However, the IRS has created a list of medical, dental, and mental health services and items via their IRS Publication 502, Medical and Dental Expenses disclosure.

HSA vs Health Insurance

An HSA is a compliment, rather than an alternative, to health insurance. It can be easy to mix up an HSA and HDHP (or other health care plans), however, a closer look can eliminate the confusion.

You put money into an HSA, and you can take it out for qualified medical expenses without a penalty or having to pay taxes on the amount. Funds from an HSA can even be used to invest in stocks and other financial securities within your HSA policy. This flexibility of funds is not an option through traditional health care plans.

An HSA is not a health insurance plan, which is why HSAs require a health plan to work. A health plan will only kick in and start paying for your medical costs after a deductible is paid out of your pocket. An HSA is an account you will pay into on an elective basis, but you still have to pay premiums to maintain your health insurance coverage. The HSA funds are used primarily to cover your insurance deductible and qualified medical expenses — all while giving you some freedom in contributing money, investing, providing tax benefits, and preparing for retirement. 

An HSA and HDHP (or another qualified health insurance plan) will work together for a comprehensive health program. Lastly, those who foresee large healthcare expenses in their future may not want to opt for an HDHP, as the deductible for these expenses will be high. It may be more worth it for these people to choose an alternative health care plan.

How Do I Get an HSA? 

To qualify for an HSA, you must carry an HDHP — for which you must be under the age of 65 to be eligible. Other than that, you can choose to get an HSA through a financial benefits company, a bank, or your employer. 

Requirements for an HSA include not having other health coverage except what is accepted under the other health coverage by the IRS, not being enrolled in Medicare, and you must not be claimed as a dependent on the previous year’s tax return by someone else. Your HSA will have some stipulations set forth by the IRS governing how you contribute to and withdraw from your HSA in order to enjoy tax-free privileges.

Contributing to Your HSA

The IRS sets annual limits to how much you (and your employer) can contribute to your HSA. Limits are set for self-only and family coverage. For 2021, The IRS contribution limits for HSAs state that you may contribute $3,600 for self-only coverage and $7,200 for family coverage under an HDHP. 

Aside from your employer, any eligible individual may contribute to your HSA, including family members. These limits will be adjusted for inflation every year, so it is important you keep an eye on what your HSA contribution restrictions are every year.

HSA Withdrawal

You can withdraw from your HSA, tax-free at any time and for any reason. However, for expenses that are not qualified (meaning anything other than health expenses), the IRS will impose a 20% penalty — as it will be treated as ordinary income. Eligible expenses include, but are not limited to:

• Ambulance fees;
• Artificial limbs and teeth;
• Birth control and fertility treatments;
• Blood sugar testing and insulin;
• Contact lenses and eyeglasses;
• Crutches;
• Dental treatments;
• Drug addiction programs;
• Drug prescriptions;
• Feminine hygiene products;
• Flu shots;
• Hearing aids;
• Over-the-counter medication;
• Surgery (excluding cosmetic surgery);
• Vasectomies;
• Wheelchairs.

For a more detailed list and explanation of exceptions, visit the Medical and Dental Expenses publication by the IRS. 

Should I Get an HSA? 

Your decision for setting up an HSA will come down to weighing the advantages and drawbacks. To truly understand if an HSA is a financially sound decision for you, consider some of the following conditions.

Pros

• HSA tax advantages: Dollars that go into your HSA account, from you, your employer, or anyone else that contributes, aren’t taxed. Additionally, the funds you withdraw and the interest earned on your money is not taxed either (although interest in HSA accounts isn’t very substantial). You can claim a tax deduction for contributions anyone makes to your HSA when reporting contributions to the IRS.

• Investing: A 401(k) and IRA are traditional investment routes, however, you can also choose your HSA as an alternative investment vehicle for a variety of investments into stocks, bonds, other financial securities.
• Retirement funding: When you turn 65, the funds you have contributed to your HSA can now be treated as a traditional IRA. You can take out the money for non-qualified expenses (with taxes, but without penalty), while qualified expenses are still tax-free. You can keep your HSA for as long as you’d like, but you won’t be able to contribute to it if you enroll in Medicare.
• Employer contributions: If your employer offers an HSA, they will often choose to “match” your contribution. Meaning that whatever money you put in (to a certain amount), they will contribute as well, tax-free.

Cons

• HSA tax disadvantages: Any expense outside of the qualified medical expenses set forth by the IRS will be taxed and you will receive a 20% penalty for doing so. For any discrepancies, it will be important you receive receipts for your medical expenses to validate them and avoid paying this tax penalty.
• Investing: You will not be able to use your HSA for any investment like a traditional investment account. Mainly, you can only use an HSA for financial securities.
• Non-qualified medical expenses: Sometimes, an expense you think is a qualified medical expense is not, such as in the case of cosmetic surgery. It will be crucial to check with the IRS’s list of qualified medical expenses to avoid a penalty.
• High deductible health plan (HDHP): You will need an HSHP to have an HSA. While you may pay a lower premium, your deductible will be high. Those with a medical condition that may require frequent hospital expenses, or those who may need to pay expenses in the future may want to choose another health plan with a lower deductible.

An HSA can be a sound financial instrument. From the moment you start one until your retirement, you (and others) can contribute tax-free dollars into it, start investing, and work on planning your retirement all while having the peace of mind that you have means set aside to pay for any medical expenses.