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Health Savings Accounts: should you open one?

As healthcare costs have risen in recent years, increasing numbers of health insurance plans carry high deductibles. More than a quarter of employers offering health benefits offer a high-deductible health plan (HDHP), according to Kaiser Family Foundation research. To help enrollees cover the costs of those high deductibles, many HDHPs are paired with health savings accounts (HSA).

If you choose a health insurance plan with a high deductible, and you meet the criteria for pairing it with an HSA, you may have some questions about how it all works. To help you make the right choices for your health and your finances, here are answers to common questions about health savings accounts.

What is an HSA?

An HSA is like a personal savings account, but the money is designated for spending on eligible healthcare expenses. Money deposited in an HSA is not taxed by the federal government, as long as it is used only for those qualified health expenses.

What is a health savings account used for?

Most people use a health savings account to set aside money to pay for out-of-pocket medical expenses while saving on taxes. Those expenses can include qualified medical, pharmacy, dental, and vision bills. Because the HSA is funded with pre-tax income, you never have to pay income taxes on that money as long as you use it for qualified purchases.

What is covered under a health savings account?

The IRS allows you to use the funds in a health savings account for a wide variety of healthcare expenses. However, the funds cannot be used to pay your health insurance premiums unless you have special circumstances, such as losing your job.

Qualified expenses include dental work, orthodontia, eyeglasses, prescription medications, over-the-counter medications, athletic braces, bandages, birth control, co-insurance, COBRA premiums, first aid kits, homeopathic medicines, and a wide variety of other health needs.

What are the advantages of a health savings account?

One of the main advantages of an HSA is that you don’t lose the funds in your account. If you don't use them all in the current year, they will simply stay in your account and continue to grow.

The funds in your HSA can be deposited into various investment vehicles, and different financial institutions will offer different investment options. If you choose to invest your HSA funds for longer term availability and avoid using them for immediate health purposes, doing so may maximize the tax-free benefits that an HSA affords. This strategy makes the HSA a valuable retirement planning tool, especially once you've maxed out your IRA and 401(k) contributions.

To enjoy the tax benefits of an HSA, funds used prior to the age of 65 must be used for a qualified health expense or be subject to income taxes and a 20% penalty. After 65, funds used for qualified health expenses continue to be tax and penalty free, while non-qualified expense face only ordinary income tax liabilities.

What are the rules for health savings accounts?

Not just anyone can use an HSA. To open and use the account, you must be covered under a high-deductible health insurance plan that includes an HSA option. The IRS guidelines for HSA eligibility do not allow the plan to provide for anything other than preventive care before the full deductible has been met. That means if the plan provides any prescription benefits or doctor visits beyond preventive care before you've met the entire deductible, your plan does not qualify for an HSA.

If you qualify for an HSA, you are allowed to contribute pre-tax dollars to the account during the years you are covered by the accompanying health plan. But there are limits to the amount you can contribute, and those limits are set by the IRS on an annual basis. In 2023, people with individual coverage can contribute up to $3,850 to an HSA, and people with family coverage can contribute up to $7,850.

What is the difference between HSA and FSA?

Health savings accounts and flexible spending accounts (FSA) are both pre-tax accounts that you can use to pay for healthcare-related expenses. However, the main difference is that you own the HSA and the money you've deposited in it, while your employer owns the FSA.

The funds in both accounts can be used to pay for qualified medical expenses on a tax-free basis, but if you don't use all the funds in your FSA before the end of the plan year, you will forfeit them. On the other hand, if you don't use the funds in your HSA before the end of the plan year, they remain available and continue to grow tax-free in your account. It's unlikely you'd have to choose between the two accounts, as the one offered is dependent on your employer and health insurance.

If your health plan qualifies for an HSA, it's worth looking into. The account can offer significant tax savings in the short term, and it can serve as a valuable tax-free retirement savings vehicle.

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