What Is a Health Savings Account?

A Health Savings Account (HSA) is a tax-advantaged account created for individuals who are covered under high-deductible health plans (HDHPs) to save for medical expenses that HDHPs do not cover. Contributions are made into the account by the individual or the individual's employer and are limited to a maximum amount each year. The contributions are invested over time and can be used to pay for qualified medical expenses, which include most medical care such as dental, vision, and over-the-counter drugs.

How an HSA Works

A Health Savings Account is one of the ways an individual can cut costs if they are faced with high deductibles. A deductible is the portion of an insurance claim that the insured pays out-of-pocket. In order to open and contribute to an HSA for themselves or their family, an individual needs to have an HSA-eligible high-deductible health plan (HDHP). An HDHP is an insurance plan that has a higher annual deductible than typical health plans.

HSA-eligible HDHPs are required to have an annual out-of pocket maximum of no more than $6,750 for single coverage and $15,800 for family coverage in 2019. (That figure rises to $6,900/$13,800 for singles/families in 2020.) Minimum deductibles are $1,350 ($1,400 in 2020) for singles and $2,700 for families ($2,800 in 2020).

When an individual has paid the portion of a claim they are responsible for, the insurance company will cover the remaining portion, as specified in the contract. For example, under the HDHP, an individual with a deductible of $1,500 who makes a medical claim for $3,500 will have to pay $1,500 since the insurer is only responsible for the excess, which is $2,000. To supplement the funds that an insured has to pay out-of-pocket, a Health Savings Account (HSA) can be used.

Key Takeaways

  • A Health Savings Account (HSA) is a tax-advantaged account to help people save for medical expenses that high-deductible health plans don't cover.
  • An HSA, owned by an employee, can be funded by the employee and the employer.
  • The contributions are invested over time and can be used to pay for qualified medical expenses.

Qualifying for an HSA

An individual who has an HDHP may qualify for a Health Savings Account. The HSA is usually paired with a qualified HDHP and offered by a health insurance provider. An HSA can also be opened at a number of financial institutions. To qualify for an HSA, the taxpayer must be eligible, as per standards set out by the Internal Revenue Service (IRS). An eligible individual is one who has a qualified HDHP, has no other health coverage, is not enrolled in Medicare, and is not dependent on someone else’s tax return.

Any eligible individual can contribute to an HSA in cash only. An HSA owned by an employee can be funded by the employee and the employer. Any other person, such as a family member, can also contribute to the HSA of an eligible individual. Individuals who are self-employed or unemployed may also contribute to an HSA, provided they meet the qualifications of owning a Health Savings Account in the first place.

For 2019, the contribution limit to an HSA is $3,500 for self-coverage. In 2020 it will rise $50 to $3,550. Individuals with families can contribute up to $7,000, rising to $7,100 in 2020. Individuals who are 55 years or older by the end of the tax year can contribute an additional $1,000 to their HSAs. Contributions made by an employer to an HSA are included in the limit. For example, an individual who opts for the maximum 2019 contribution limit of $3,500 can contribute only $2,000 if their employer contributes $1,500.

The 2019 HSA contribution limits are $3,500 for a self-only account and $7,000 for a family account.

Tax Advantages of an HSA

HSAs have a number of advantages (as well as drawbacks). The HSA is most advantageous to account owners because funds are contributed to the account using pre-tax income. The portion of pre-tax income that is used to fund an HSA lowers a taxpayer’s total taxable income, translating into a lower tax liability for the individual.

In addition, contributions made to an HSA are 100% tax-deductible, and any interest earned in the account is tax-free. However, excess contributions made to an HSA incur a 6% tax and are not tax-deductible. Aside from a few administrative changes, the Tax Cuts and Jobs Act of 2017 did not directly affect HSAs.

The most obvious key drawback: You need to be a good candidate for an HDHP. Healthy people with limited medical expenses who will benefit from paying lower premiums and affluent families who will benefit from the tax advantages and can afford the risk of higher deductibles are two groups who fit these parameters well.

Withdrawals Permitted Under an HSA

As long as withdrawals from a Health Savings Account are used to pay for qualified medical expenses that are not covered under the HDHP, the amount withdrawn will not be taxed.

  • Qualified medical expenses include deductibles, dental services, vision care, prescription drugs, co-pays, psychiatric treatments, and other qualified medical expenses not covered by a health insurance plan.
  • Insurance premiums usually don’t count towards qualified medical expenses unless the premiums are for Medicare or other healthcare coverage if 65 years or older, for healthcare insurance while unemployed and receiving unemployment compensation and for long-term care insurance.

If any distributions are made from an HSA for reasons other than paying for medical expenses, the amount that is withdrawn will be subject to both income tax and an additional 20% tax penalty. Individuals who are 65 years old or older will no longer be able to contribute to an HSA but can withdraw any funds accumulated in the account for any expense without incurring the 20% penalty. However, income tax will still apply to any non-medical usage.

HSA Contribution Rules

Contributions made to an HSA do not have to be used or withdrawn during the tax year. Any unused contributions can be rolled over to the following year. Also, an HSA is portable, meaning that if an employee changes jobs, they can still keep their HSA. In addition, an HSA plan can be transferred to a surviving spouse tax-free upon the death of the account holder. On the downside, HSAs come with specific withdrawal rules and a recordkeeping burden that may be difficult to maintain.

HSA vs. Flexible Savings Account

The Health Savings Account is often compared with the Flexible Savings Account (FSA). While both accounts can be used for medical expenses, some key differences exist between them. For example, unused funds in the FSA during a given tax year are forfeited once the year ends. Also, while the elected contribution amount for the year can be changed by an employee with an HSA anytime during the year, the elected contribution amount for an FSA is fixed and can only be changed at the beginning of the following tax year.

Health Savings Accounts should not be confused with Health Spending Accounts, which are used by employers in Canada to provide health and dental benefits for their employees residing in Canada.