Does your health insurance come with deductibles in the four figures? If so, you're probably eligible to establish a Health Savings Account (HSA). Used in combination with a High-Deductible Health Plan (HDHP), funds deposited in a HSA can go towards paying medical bills until the plan's deductible is met and your healthcare coverage goes into effect.

HSAs were established in 2003, as part of the Medicare Prescription Drug, Improvement, and Modernization Act. These savings accounts have become an increasingly popular option for consumers seeking to manage their healthcare costs. They also work as a tax-advantaged savings tool as well.

Key Takeaways

  • HSAs let you set aside pre-tax income to cover healthcare costs that your insurance doesn't pay.
  • You can only open and contribute to a HSA if you have a qualifying high-deductible health plan.
  • For 2020, the maximum contribution amounts are $3,550 for individuals and $7,100 for family coverage. If you are 55 or older, you can add up to $1,000 more as a catch-up contribution.
  • HSAs have no use-it-or-lose-it provision. Any funds still in the plan at the end of the year can be rolled over indefinitely.

Who Can Open a Health Savings Account?

According to federal guidelines, you can open and contribute to a HSA if you:

  • Are covered under a qualifying high-deductible health plan which meets the minimum deductible and the maximum out of pocket threshold for the year
  • Are not covered by any other medical plan, such as that for a spouse
  • Are not enrolled in Medicare
  • Are not enrolled in TRICARE or TRICARE for Life
  • Are not claimed as a dependent on someone else's tax return
  • Are not covered by medical benefits from the Veterans Administration
  • Do not have any disqualifying alternative medical savings accounts, like a Flexible Spending Account or Health Reimbursement Account

What Qualifies as a High-Deductible Health Plan?

Generally speaking, a HDHP is a healthcare plan that trades relatively low premiums for relatively high deductibles, as its name implies. To qualify for a HSA that can be opened in combination with a HDHP, the HDHP must meet certain criteria. The IRS establishes guidelines each year, adjusting the figures for inflation. In 2020, a HSA account can only be opened if the account owner’s plan meets the following qualifying criteria:

2020 High-Deductible Health Plan Rules
  Individuals Families
Minimum Deductible $1,400 $2,800
Out-of-Pocket Maximum* (includes deductibles, co-payments, co-insurance) $6,900 $13,800

*Note that the out-of-pocket maximum is also designated by the plan. It can include deductibles, co-payments, and co-insurance. It does not include insurance premiums. The out-of-pocket maximum will usually also not include out of network services.

How Does a Health Savings Account Work?

Contributions to a HSA are tax-deductible. This means contributions will be deducted by payroll for employer-sponsored plans. For other individuals, mainly the self-employed, deductions can be taken when tax filings are made for the year.

Withdrawals from a HSA are tax-free provided they're used to pay for qualified medical expenses. These expenses can include payments for dental and vision care—expenditures that some standard medical health insurance plans may not cover.

Most HSAs issue a debit card, so you can pay for prescription medications and other eligible expenses with the card. If you wait for a bill to come in the mail, you can call the billing center and make a payment over the phone using your debit card.

Any money that is in your account at the end of the year remains in your account to pay for future qualified medical expenses. End of year balances are carried over indefinitely. The account and its funds belong to you, and you retain ownership even if you change health insurance plans, change jobs, or retire. While it's in the account, the money grows tax-free.

How Much Can I Contribute to a HSA?

The IRS sets limits that determine the combined amount that you, your employer, and any other person can contribute to your HSA each year. For 2020, the maximum contribution amounts are $3,550 for individual coverage and $7,100 for family coverage. You can add up to $1,000 more as a "catch-up" contribution if you are age 55 or older.

How Can I Use HSA Money?

The funds in your HSA can be used to pay for qualified medical expenses incurred by you, your spouse, and your dependents. The IRS establishes what is and what is not a qualified medical expense, detailed in IRS Publication 502, Medical and Dental Expenses. Generally speaking, qualified expenses include nearly any medical expense you may incur, such as amounts paid for diagnostics, cures, mitigations, treatments, and prescribed preventative medications.

One of the greatest benefits of the HSA is that it can be used to make payments that count towards your deductible. Moreover, the HSA serves as a type of tax shelter, meaning you won’t pay any taxes on the money you contribute. This saves you the taxable amount while allowing you to put those funds towards medical expenses you would have likely paid anyway with after-tax dollars. Keep in mind that you can also use the account for more than the expenses you incur under your main health insurance plan. For example, if your medical plan doesn't cover dental or vision care, HSA funds could still be used for those bills.

There are a few things that a HSA cannot be used for. You can't use it to pay insurance premiums. Other ineligible expenses include over the counter items like toothpaste, toiletries, and cosmetics, as well as most cosmetic surgeries. A vacation to a healthier climate would also not be an option.

Over the counter costs that don't require a prescription are generally not allowed such as the costs of toothpaste, toiletries, and cosmetics, as well as nicotine gum or nicotine patches.

If you're 64 or younger and withdraw funds for a non-qualified expense, you'll owe taxes on the money (which will be taxed as income), plus a 20% penalty. If you're 65 or over, or disabled at any age, you'll still owe taxes on the amount but be spared the penalty. So, frankly, after age 65, you can essentially withdraw HSA funds for anything.

How Can I Set Up a HSA?

You first need to enroll for a HDHP. If you take that step through your employer's human resources department, it should be able to advise you on creating your HSA. Most employer-sponsored HDHPs have an associated HSA provider for you to work with.

If a HSA does not come with your HDHP, you can setup the account on your own. Banks, credit unions, and brokerages all offer HSAs. Each HSA provider can create their own terms. HSAs through a brokerage can allow you to potentially invest your contributions in stocks, bonds, or funds. Bank HSAs will usually offer an optimal interest rate.

Once you select a provider, the enrollment process is fairly straightforward: You will be required to complete an application with information on your HDHP. Once your account is approved you can fund the account and begin using it for qualified expenses.

HSAs as Savings/Investing Tools

HSAs offer a tax shelter. For savvy investors this can create an opportunity to accumulate capital gains that can be withdrawn tax-free for medical expenses. Investment options, of course, can become more important if you have a larger HSA balance.

Most HSA account holders will want to be somewhat conservative with these funds since they are intended for necessary, planned and unplanned medical usage. This can limit the types of investments an account holder may want to make with their HSA contributions to mostly low risk products like Treasuries, municipal bonds, or high-grade corporate bonds.

The type of account opened will dictate the type of investments that may be available. Plans provided through banks usually offer no more than high yield interest savings terms. Brokerage plans however, offer much more. Some of the top HSA investment platforms that you may want to research include Vanguard, HSA Bank/TD Ameritrade,  Lively, Optum Bank, and Health Savings Administrators.

Who Benefits Most from a HSA?

HDHPs and HSAs often make the most sense for people who are relatively healthy with minimal expectations for annual healthcare costs. HDHPs usually offer lower premiums for the tradeoff of higher deductibles that would need to be paid if an emergency arises. This is what makes the combination of a HDHP and HSA very beneficial. Plan owners can potentially save indefinitely through a HSA for any emergencies that may require a high deductible payment.

HSAs and HDHPs can also appeal to high income earners as well as individuals nearing the age of 65. High income earners choosing a HDHP can potentially use HSAs to save up to $8,100 per year in a tax-sheltered account. For both high income earners and those approaching retirement, the HSA can be a worthwhile vehicle for building a medical emergency fund while also saving in a type of alternative retirement vehicle.

Conversely, be aware that if you incur substantial health costs for standard medical care, the high-deductible health plan required to open a HSA might not be the right choice for you. Even though you will pay less in premiums with the HDHP, it could be difficult—even with money in a HSA—to come up with the cash to meet the deductible for a costly medical procedure.