What is a health savings account and how does it work?

Have you ever wanted to find a better way to budget for medical expenses? There are ways to save for medical costs ahead of time. A health savings account (HSA) might help you use pretax dollars to save for qualified health care expenses. 

And, in addition to saving for health care expenses, an HSA could help you offset your taxable income. You may even be able to invest any remaining HSA funds for retirement. Read on to learn more about health saving accounts and how they work. 

Key takeaways: 

  • An HSA lets individuals with high deductible health plans (HDHPs) save pretax money for qualified medical expenses. 
  • The IRS decides which health care plans are eligible for HSAs.
  • HDHPs usually require you to pay a higher amount before insurance coverage kicks in, but they typically have a lower monthly premium. 
  • HDHPs can be combined with HSAs to offset high out-of-pocket expenses.
  • HSAs may cover expenses such as copays, prescriptions and dental and vision care. 
  • HSAs may be offered through employers, health care marketplaces and banks.
  • HSAs and flexible spending accounts (FSAs) offer similar tax advantages, but FSAs typically aren’t as flexible as HSAs.

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What is an HSA?

Health savings accounts allow people to save before-tax money for qualified medical expenses. HSA funds can be used to cover medical costs such as doctors’ appointments, therapy, prescription drugs and more.

If you have an HDHP, you may be eligible for an HSA. Typically, the funds in an HSA don’t expire and unused funds sometimes earn interest. 

How an HSA works 

Think of an HSA as a savings account that allows you to put aside tax-exempt savings for qualified medical costs. To qualify for an HSA, you usually need to be enrolled in an eligible HDHP. 

You may be wondering if your HDHP is eligible for an HSA. The IRS defines HDHPs as insurance plans that have a minimum deductible of $1,400 for one person and $2,800 for a family. And an HDHP out-of-pocket maximum can’t exceed $7,050 for an individual or $14,100 for a family. 

Be advised: These out-of-pocket maximums refer to in-network providers only. If your health care plan meets these minimum and maximum out-of-pocket deductibles, you may qualify for an HSA. 

There are many potential benefits of an HSA. When you deposit money into an HSA, these deposits are considered before-tax contributions. And if you make contributions to your HSA, you could lower your taxable income. In 2022, the maximum HSA contributions are $3,650 for an individual and $7,300 for a family.

You can use HSA funds to pay for qualified medical expenses. And you don’t have to worry about taxes when you withdraw your money. But the money has to be used for qualified medical expenses. Eligible medical expenses may include:

  • Physical and psychological therapy 
  • Prescription drugs and lab tests
  • Doctor’s office visits, hospital services and preventative care
  • Vision and dental care
  • Acupuncture 
  • Medical equipment, such as hearing aids

These accounts can also earn interest over time. That’s because you get to keep any money you don’t use. Sometimes you can invest your leftover HSA funds for retirement. You may be able to use your HSA funds for nonmedical expenses once you reach 65. 

HSA requirements 

If you want to enroll in an HSA, you may need to meet the following requirements:

  • Be enrolled in an IRS-approved HDHP. These plans usually have lower monthly premiums but the out-of-pocket expenses are usually higher. 
  • Not be claimed as a dependent on another person’s tax return.
  • Not be covered by Medicare or other health insurance plans.
  • Not have competing accounts, such as a flexible spending account (FSA).

HSA account benefits

There are many potential benefits to opening an HSA. 

Typically, the funds in an HSA are yours to keep, and the money doesn’t expire. Certain employers may even contribute money to the account. Plus, if you change jobs, you shouldn’t lose your HSA. Here are some other potential benefits of HSAs:

  • Your HSA doesn't expire. Unused funds automatically roll over to the next year.
  • The money saved in your HSA are before-tax contributions and can offset your taxable income.
  • Your HSA balance can earn interest. If you don’t spend HSA funds on qualified health care expenses, you might have the option to invest these funds.
  • If you have dependents, you could use your HSA funds to cover their medical costs.

Health savings account contributions and withdrawals

Almost anyone can deposit funds into your HSA. For example, your spouse, your employer, or even your children may be able to contribute funds to your HSA. But there are limits when it comes to the amount of money that can be contributed each year. 

If you enroll in Medicare, you likely won’t be able to contribute more funds to your HSA. But you can use any existing HSA funds to cover qualified expenses. 

For 2022, the yearly maximum contribution limits include:

  • Individual plan: $3,650. But people who are older than 55 can deposit an additional $1,000 as a “catch-up” contribution.
  • Family member plan: $7,300.

HSA contribution limits are determined by factors such as age, plan type and when you‘re eligible to receive an HSA. The rules for withdrawing money from your HSA depend on your age and your insurance coverage:

  • If you’re older than 65: You can use your tax-free HSA savings for qualified medical expenses and use the penalty-free savings as you wish. You’ll just have to pay income tax if you use the money for non-medical expenses.
  • If you’re younger than 65: You can use your tax-free HSA savings for qualified medical expenses. If you spend your funds on non-qualified medical expenses, the IRS will view these purchases as taxable income. And you may have to pay a 20% income tax penalty.
  • If you have Medicare insurance: You won’t be able to contribute to your HSA. But you can use existing HSA savings for qualified medical costs not covered by Medicare.

HSA accounts vs. FSA accounts 

Flexible spending accounts have benefits that are similar to HSAs. An FSA also allows individuals to save for medical expenses with before-tax money. But FSAs are only offered through employers, whereas HSA accounts are owned by individuals. And you can transfer HSA funds even if you change employers, but unused FSA funds could expire when you change jobs.

If you have unused FSA funds, your employer may:

  • Grant you a grace period to use the funds.
  • Transfer a maximum of $570 into the following year’s savings. 
  • Make you forfeit the unused funds at the end of the year.

Since FSAs are provided by your employer, you can’t use the funds once you leave your job. Also, if the FSA funds are used for non-medical expenses, you may be required to reimburse the account. 

Individuals can change their FSA contributions if they switch their plan during enrollment, if their family circumstances shift or if they switch jobs. But HSA contributions may change at any time, and the maximum annual contribution for FSAs is slightly lower than for HSAs. The maximum annual FSA contribution is $2,850 for an individual.

HSA disadvantages

There can be some disadvantages to enrolling in an HSA. 

HSA limitations may include:

  • You must be enrolled in a qualified HDHP to qualify for an HSA. 
  • You may face tax penalties if you don’t meet the age requirement to use your savings for non-medical expenses.
  • You usually can’t use your HSA to pay your insurance premium.
  • You’re subject to a yearly contribution limit to your HSA.

How to enroll in an HSA

You may be able to enroll in a qualified HDHP through your employer. And high-deductible health plans can also be found through health care marketplaces. 

If you want to enroll in an HSA, you may want to check that your HDHP meets the IRS eligibility requirements. It’s important to do your research so that you can make the best decision for your or your family’s needs.

HSAs in a nutshell

Whether you need to budget for doctors’ visits, dental services or therapy, HSAs may help you offset healthcare expenses. And you could invest unused HSA funds to help you save for retirement

When you shop for health insurance, you may want to see whether HSA options are available for your insurance plan. An HSA can help you offset your taxable income and help you pay for out-of-pocket medical costs. 

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