As we age, medical costs often rise and as healthcare improves and preventative care becomes more common place, healthcare expenses, even for the most healthy of people, can be high. Because of this, the federal government has set up accounts that come with handsome tax advantages.
Although these accounts exist, many consumers either have never heard of them or don't understand them enough to feel comfortable contributing money, even though the tax advantages are substantial. There are numerous types of accounts, but only two are commonly seen among employees. What are these two accounts and which one should you choose?
Health Savings Account
A health savings account (HSA) is offered in conjunction with a high deductible health insurance policy. In order to better control healthcare costs, employers may enroll their employees in a high-deductible plan and deposit all or a portion of the deductible into an HSA for you to use until the deductible is met, and the health insurance policy takes over the financial burden.
Once the account is set up, employees may contribute additional funds to the HSA on a tax-free basis. Contributions made by the employer can be taken from your gross income, which makes it tax free.
Providing you use your HSA funds to pay for qualified medical expenses, the withdrawals you make from the account will most likely be tax free. Not only can your HSA be used for doctor visits or hospital stays, but other qualified medical expenses include eyeglasses, contacts, chiropractic care and prescription drugs. Finally, the HSA is a portable account allowing you to keep your account even if you switch jobs.
In order to qualify for an HSA, you have to be enrolled in a high-deductible health plan, have no other health coverage in most cases, cannot be a claimed as a dependent on somebody else's taxes and must not be receiving Medicare.
Flexible Spending Account
A flexible spending account (FSA) has many of the same advantages as an HSA, but with a few key differences. Like the HSA, you can contribute to a FSA using your gross pay making the contributions tax free. As long as you use the funds to pay for qualified medical expenses, you most likely won't have to pay taxes on any withdrawals.
Unlike an HSA, you have to declare how much you would like your employer to deduct from your gross pay in order to fund your FSA each calendar year. Once the declaration is made, you generally can't change it and if you declined the FSA during the open enrollment period, you will probably have to wait until the next open enrollment.
Your declared funds must be spent within the tax year, although a small grace period is sometimes granted up until the tax filing deadline. For this reason, it's important not to over contribute to this account as the money may be lost if you don't spend all of the funds.
Child care expenses can also be declared as a pretax withholding in a FSA, but just like the medical expenses, all funds must be used within one year. To qualify for a FSA, you must be employed by an outside employer making self-employed individuals ineligible for participation. You don't have to be covered under a health insurance policy as you do with an HSA, but it's important to note that FSA funds do not take the place of health insurance. It would be better to put those funds towards health insurance instead of a FSA if you can't afford both.
Which Should I Pick?
An HSA is a better choice if you qualify because the funds can be held over to future years. For those who contribute a larger amount, the funds may gain interest that is tax free. Because the high deductible health plan is still gaining traction as the corporate plan of choice, there is still a large amount of Americans who don't qualify for the HSA. If you are enrolled in a high deductible health plan, you will automatically be enrolled in an HSA. Since you have the option of contributing extra funds to the account, the HSA can take the place of the FSA for the additional medical expenses.
Still, many companies offer both plans. For people who have children who require daycare, while the parent or parents are at work, an FSA where one can contribute pretax dollars to pay for childcare may represent an annual savings of more than $1,000. There are annual contribution limits that are set by the IRS each year for these accounts. Check with the IRS or your employer for contribution limits.
The Bottom Line
The IRS understands the cost of healthcare and wants to help ease the burden of these expenses. The best way to realize those gains is by using your HSA to its full potential and supplementing that with a FSA for childcare expenses.