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 an HSA can go towards paying medical bills until the plan's deductible is met, and your healthcare coverage goes into effect.

Established in 2003, as part of the Medicare Prescription Drug, Improvement, and Modernization Act, Health Savings Accounts have become an increasingly popular option for consumers seeking to manage their healthcare costs. But they can also work as a tax-advantaged savings tool as well.

MHSAs are used in combination with a High-Deductible Health Plan (HDHP). The HDHP trades relatively low premiums for relatively high deductibles. The Health Savings Account is used to help pay healthcare costs until the deductible is met.

Key Takeaways

  • A health savings account (HSA) lets you set aside pretax income to cover health care costs that your insurance doesn't pay.
  • You can contribute to an HSA only if you have a high-deductible health plan (HDHP) and aren't enrolled in Medicare.
  • For 2019, the maximum contribution amounts are $3,500 for individuals and $7,000 for family coverage. If you're 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 an HSA if you:

  • Are covered under a high-deductible health plan
  • Are not covered by any other non-HDHP plan, such as that for a spouse (there are exceptions for certain plans with limited coverage, such as dental, vision and disability)
  • Are not enrolled in Medicare
  • Are not claimed as a dependent on someone else's tax return

What Qualifies as a High-Deductible Health Plan?

Generally speaking, an HDHP is a healthcare plan that trades relatively low premiums for relatively high deductibles, as its name implies. But to officially qualify as an HDHP, your medical insurance has to meet certain criteria. The IRS establishes guidelines each year, adjusting the figures for inflation. These are the limits for 2019.

2019 High-Deductible Health Plan Rules
  Individuals Families
Minimum Deductible $1,350 $2,700
Out-of-Pocket Maximum (includes deductibles, co-payments, co-insurance) $6,750 $13,500

Note that the out-of-pocket maximum includes deductibles, co-payments, and co-insurance—but not insurance premiums.

How Does a Health Savings Account Work?

Contributions to the HSA are tax-deductible or, if made as payroll deductions, on a pre-tax basis. Withdrawals are tax-free provided they're used to pay for qualified medical expenses, which include those for dental and vision care—expenditures that many traditional health insurance plans may not cover.

Most HSAs issue a debit card, so you can pay for prescription medications and other eligible expenses right away. 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. And it does so 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 an 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 2019, the maximum contribution amounts are $3,500 for individual coverage and $7,000 for family coverage. You can add up to $1,000 more as a "catch-up" contribution if you are age 55 or older at the end of the year.

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 amounts paid to diagnose, cure, mitigate, treat, or prevent disease, and to treat conditions that affect any part or function of the body.

Keep in mind that you can use the account for more than the expenses you incur under your main health insurance plan. For example, if your plan doesn't cover dental or vision care, HSA could be especially helpful in meeting these bills.

However, you can't use it to pay insurance premiums, with the exception of those for supplementary Medicare coverage or long-term care insurance. Other ineligible expenses include the cost of toothpaste, toiletries, cosmetics, and most cosmetic surgery. And the vacation you made to a healthier climate? Don't even think of tapping your HSA.

Basically, pharmaceutical or quasi-medical items that don't require a prescription, like nicotine gum and nicotine patches, cannot be covered with HSA funds.

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 an HSA?

You first need to enroll for an HDHP. If you take that step through your employer's human resources department, it should be able to advise you on creating an HSA. If HR can't, contact your health insurance company for help with setting up an HSA through its recommended bank.

Alternatively, ask your own bank or credit union if it offers HSAs and can provide you with enrollment information. You can also look online (try an Internet search for "HSA providers").

Once you select a bank, the enrollment process is fairly straightforward: You complete an application and fund the account. After that, you can begin to use the funds for qualified expenses.

HSAs as Savings/Investing Tools

Along with the aid they offer in paying medical bills, Health Savings Accounts can work as smart investments.

An HSA account offers a triple tax advantage:

  1. Your contributions are tax-deductible, so they lower your tax bill. If your contributions are deducted from your paycheck, they're made with pre-tax dollars.
  2. Withdrawals are tax-free if they're used to pay for healthcare expenses, including dental and vision care. It's effectively like getting a discount on your medical bills.
  3. Once you reach age 65 (or you have a disability at any age), nonmedical withdrawals are taxed at your current tax rate.

With these tax advantages, it makes sense to max out an HSA if you're able to.

Another key consideration is how your HSA plan allows you to invest your money. Some plans provided through banks are no more than savings plans, which won’t allow your funds to grow much. However, you can find plans that offer more investment alternatives, such as HSABank, which has a TD Ameritrade self-directed brokerage option, or Health Savings Administrators, which includes 400 mutual-fund options for your HSA account. Investment options, of course, become more important if you have a larger HSA balance.

Who Benefits Most From an HSA?

Families who can afford four-figure deductibles can use the HSA that comes with an HDHP as a way to save $7,000 per year tax-free until retirement. That's why HSAs appeal to many high-income earners. Along getting with a tax-deferred savings account, their payroll taxes are lessened due to the HSA contributions. Their insurance premiums are usually lower with the HDHP, too.

HSAs also make the most sense for people who are relatively healthy, with minimal healthcare costs now—and who want to save for their presumably larger healthcare needs in old age. They can use the HSA to pay for expenses that health insurance and Medicare cover poorly, or don't pay at all. That includes long-term care, hearing aids, eye care, and dental care. Of course, if unexpectedly high or uncovered medical expenses occur earlier, they can always use the account to pay them, if they need to.

And, as noted earlier, while you're supposed to use HSA funds for medical expenses, the lack of a penalty if you don't, after age 65, really means you can use the money for anything.

Conversely, be aware that if you incur substantial health costs for standard medical care, the high-deductible health plan required to open an 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 an HSA—to come up with the cash to meet the deductible for a costly medical procedure. But, if you already have a qualified HDHP, an HSA could definitely be good for your financial health.