What’s a Health Savings Account (HSA)? Do I need one?

People with high deductible health insurance plans can enroll in a health savings account (HSA) to help pay for their medical expenses.

Piggy bank on Health savings account paperwork

Of all the confusing alphabet soup of acronyms you might come across when shopping for health insurance, “HSA” might be the most mystifying.

It stands for “health savings account,” and it is not really a health insurance plan. Instead, it’s a way to set aside money to pay for health care.

HSAs offer tax breaks, so you may pay less in federal income taxes. The money you save in taxes can help you pay for some of your medical expenses not covered by your insurance.

What’s an HSA?

Like the name says, an HSA is a savings account, similar to a regular bank savings account except that you can use the money in the account only to pay for certain health care expenses, such as doctors’ bills and prescription medications.

An HSA is like an individual retirement account (IRA) except you’re saving for medical expenses rather than retirement. If you don’t need to spend the money for health expenses right now, you can save and invest the money in the account for future expenses.

The money in the account is always yours – you do not lose the money if you do not spend it within a certain period of time or if you change jobs. That’s a key difference from a “flexible savings account,” or FSA. In an FSA, you set aside money tax-free for health care expenses each year. If you don’t spend the money by the end of the year, you lose it.

Health savings accounts can be set up only with certain types of health insurance plans – called “high-deductible health plans” or HDHPs. When you’re shopping, you will see the letters HDHP or HSA in the names of these plans. Because they have high deductibles, HSA plans are often the least expensive health plans offered by insurance companies.

Health savings accounts come with many rules, so you should make sure you understand them before opening one. And even if you do buy a plan that is eligible for a HSA, you don’t have to set up the account.

How HSAs Work – The Basics

If you have an eligible high-deductible health plan – through either your employer or one you buy on your own — you can set up a health savings account. Right now, the deductibles must be at least $1,300 a year for an individual or $2,600 for a family, but they can be much higher.

Your employer or your health insurance company will help you set up your account. Once your account is set up, you can transfer money into it, either in monthly installments or in a lump sum near the end of the tax year.

The federal government sets limits on how much you can put into your account each year. In 2017, it was $3,400 for an individual and $6,750 for a family. If you have a plan through your employer, you can have your funds withdrawn, pre-tax, from your paycheck.

Some employers contribute money, also pre-tax, to their employees’ accounts. You can also make your contributions directly into your account and deduct them on your tax return.

Once you have money in your account, you can use it to pay for medical expenses that your insurance doesn’t cover, including your copayments and deductible. The IRS provides a long list of eligible expenses and things the money cannot be used for, such as cosmetic surgery.

You will be given a debit card that you will use to pay for eligible expenses. When you take money out of your account for eligible expenses, the withdrawals are not taxable. If you use the money for non-eligible expenses, you will have to pay taxes and a penalty on that money. You will get monthly statements, just like your bank statement, showing your deposits (contributions), withdrawals (spending) and any investment earnings.

If you don’t use some or all of the money in your HSA, you can invest the money. The company that sets up your account will provide a variety of investment options for you, such as mutual funds. Any money you earn on your investments is tax-free when you withdraw it.

For the reasons mentioned above, HSAs are often described as having “triple tax benefits” – money put into the accounts reduces your taxable income, spending on eligible expenses is tax-free, and investment earnings are not taxed.

Is an HSA Right for You?

  • Does your employer contribute money to your HSA? Some employers will match what you contribute to your HSA. For example, if you put $1,000 of your own money into your account, your employer may also put $1,000 into your account. So that is “free money” for you. In addition, you don’t pay taxes on either the money you contribute or the money your employer contributes.
  • Are you financially comfortable? Generally, HSAs are more attractive to higher-income individuals or families, that can afford to set money aside in a health savings account, that benefit from their tax advantages, and that can afford to pay the higher deductibles that come with HSA plans.
  • Do you have “extra” money to set aside for a health savings account? If you can barely cover your day-to-day or monthly living expenses or rarely have money left over, you probably won’t be able to set aside money in an HSA. Some financial advisors say you should set aside money for a rainy-day emergency fund, a college fund for your children and/or a retirement fund for yourself before you consider an HSA.
  • Would you benefit from the tax advantages of an HSA? If your income is relatively low and you fall into low tax brackets, an HSA may not provide many tax savings to you.
  • Are you healthy with few medical expenses? Since HSAs are offered only with high-deductible health plans, you must pay a relatively high amount out of your own pocket before your health insurance coverage starts paying. If you don’t have many medical expenses, this probably isn’t a problem. But if you or your family have a lot of medical issues and expenses, this kind of plan may not be for you.
  • Are you comfortable and savvy managing bank accounts, investments, and paperwork? You will have a separate debit card for your HSA to pay medical bills and monthly bank account statements. Since one of the advantages of HSAs is to allow you to invest money in your account tax-free, to take advantage of this you will need to decide how to invest the money and track your investments. In addition, you need to report your HSA contributions on your federal income tax return. And you are required to save your receipts for medical expenses you pay out of your account so you can prove to the IRS that the expenses are eligible.

Learn More About the Official Rules From the IRS

HSAs were created by the US government to encourage people to save money for health care. They do so by providing tax breaks. For that reason, many of the rules about HSAs come from the Internal Revenue Service – the agency that you file your federal income tax returns with.

Here are two important IRS documents you should read to learn more about the details of HSAs:

IRS Publication 969: https://www.irs.gov/publications/p969/ar02.html

IRS Publication 502, Eligible Medical and Dental Expenses: https://www.irs.gov/pub/irs-pdf/p502.pdf

HSA FAQ

Q. Can I take money out of my HSA if I need it for something other than medical expenses?

A: Yes you can but you’ll have to pay taxes and a 20 percent penalty. If you’re 65 or older or disabled, you’ll have to pay taxes but there is no penalty.

Q. What happens if I use money in my HSA to pay for something that isn’t allowed?

A. In addition to having to pay taxes and penalties, your tax return could be audited by the IRS. Save your receipts for everything you purchase out of your HSA in case the IRS wants to see them.

Q. What exactly is a “high-deductible health plan”?

A. A deductible is the amount of money you pay out of your own pocket for medical care before your health insurance plan starts paying. With a high-deductible plan, you would pay more than with a traditional plan. In return, your monthly premium payment is usually lower. The law requires HDHPs to have deductibles of at least $1,300 for an individual or $2,600 for a family. But many HDHPs have much higher deductibles – such as $5,000 to $7,000.

Q. I’ve heard that if I don’t use the money in my account, I lose it. Is that true?

A. No. You’re thinking of a “flexible spending account” or FSA. That’s something different. An FSA is set up through your employer to pay for some of your medical expenses. You decide how much money you want taken out of your paycheck for the year and put into an FSA. You don’t have to pay taxes on this money. If you don’t spend the money in your account by the end of the year, you lose that money.

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