What Are the Pros and Cons of a Health Savings Account (HSA)?

HSAs are portable and offer tax advantages, but they have some drawbacks

Pros And Cons Of A Health Savings Account

A health savings account offers a way to save while paying for healthcare expenses.To be eligible for an HSA, you must enroll in a high-deductible health plan, or HDHP. These plans have high deductibles, but their monthly premiums are lower than plans with lower deductibles. They are intended to cover serious illness or injury.To open and contribute to an HSA, you must be covered under a HDHP on the first day of the month, you cannot be covered by a non-HDHP plan or enrolled in Medicare, and no one can claim you as a dependent on a tax return.Among their many advantages, HSAs:Permit others to contribute to your HSAAllow pre-tax and tax-deductible contributionsAllow tax-free withdrawalsLet funds roll over to the next yearOffer portability if you change plans or retire Their disadvantages include:High deductiblesMoney can only be used for qualified healthcare expensesUnexpected healthcare costs might exceed what’s saved in the HSAThe pressure to saveTaxes and penalties on withdrawals for non-qualified expenses before 65Recordkeeping requirementsFeesThere are hundreds of health expenses that qualify for payment from an HSA. Examples include chiropractic or dental treatments, fertility services, wheelchairs and prescription medications.Contributions to an HSA can be made any time during the calendar year and up to April 15 of the following tax year. The IRS sets contribution limits.

Reviewed by Thomas J. CatalanoFact checked by Rukshani LyeReviewed by Thomas J. CatalanoFact checked by Rukshani Lye

A health savings account (HSA) is essentially a personal savings account that can be used only for medical expenses. To be eligible, you must be enrolled in a high-deductible health plan (HDHP). HSAs have certain tax advantages, so many people use them as retirement plans alongside their 401(k) or IRA accounts.

Contributions to an HSA are made with pretax dollars. This means that you won’t pay income tax on the money that you put directly into your HSA. On the other hand, the money that you put into your HSA is expensive to access once it’s already in the account unless it is used properly.

Key Takeaways

• The health savings account (HSA) helps people with high-deductible health insurance plans cover out-of-pocket medical costs.
• Contributions to HSAs aren’t subject to federal income tax, and earnings in the account grow tax-free.
• Unspent money in an HSA rolls over at the end of the year, so it’s available for future health expenses.
• You’ll owe income taxes plus a 20% penalty if you withdraw funds from your HSA for non-qualified expenses before you turn age 65.

Understanding Health Savings Accounts (HSAs)

A health savings account (HSA) is a tax-exempt savings account that is available only to people who have high-deductible health insurance plans. The money in an HSA can be used only to pay for qualified medical expenses. If the money is spent for any other purpose, the account holder has to pay income tax on the withdrawal plus a 20% tax penalty (unless the person is age 65 or older, in which case the penalty is waived).

Who Is Eligible for an HSA?

People with an HDHP can open an HSA. The two are usually paired together, so you’ll be offered an HSA when you enroll in a qualifying HDHP plan through an HSA provider.

You must also meet the eligibility standards set by the Internal Revenue Service (IRS). An eligible individual is someone who:

• Has a qualified HDHP
• Has no other health coverage
• Is not enrolled in Medicare
• Is not claimed as a dependent on someone else’s tax return

Is It Worth It to Have an HSA?

It can be worthwhile to have an HSA for the tax advantages alone. The money that you contribute to an HSA is tax-free, so you lower your tax bill by routing money that you can use for medical expenses through an HSA. Your employer won’t withhold income taxes on this money either.

On the downside, an HSA is open only to people with HDHPs, and a high-deductible plan is not for everyone. The financial benefit of an HDHP’s lower premium and higher deductible structure depends on your personal situation. The higher deductible means you’ll pay more for your out-of-pocket expenses, but you can also use the HSA to cover those costs. Generally, healthy people with no ongoing issues that require regular treatment may find them worthwhile.

Does HSA Money Expire?

The money you put in your HSA has no expiration date and will stay in your account forever–even after you retire. This means that unspent money in an HSA rolls over at the end of the year and remains available for future health expenses.

This is unlike flexible spending accounts (FSAs), which are available to many through their employers, FSAs are strictly “use it or lose it”, requiring you to spend all the funds by the end of each year or shortly thereafter.

Note

You generally cannot contribute to an HSA and a traditional FSA in the same year. However, some plans allow you to have an HSA alongside a limited-purpose FSA (LPFSA) for dental and vision costs plus a  Dependent Care FSA (DCFSA) for childcare costs.

What Can HSA Funds Be Used for?

Money that you withdraw from your HSA isn’t taxed as long as it is used for a qualified medical expense for you, your spouse, and your dependent children (even if they are not covered by the HDHP). The list of permitted expenses is quite long, and includes 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 don’t count as a qualified medical expense with some exceptions: premiums for Medicare or other healthcare coverage for people 65 or older; for healthcare continuation coverage (COBRA) while receiving unemployment compensation; or for long-term care insurance, subject to annually adjusted limits.

Premiums for Medicare supplemental or Medigap policies are not treated as qualified medical expenses.

If you use your HSA to pay for anything other than a qualified medical expense, that amount is subject to both income tax and an additional 20% tax penalty if you are less than 65 years old. After you reach age 65, you only have to pay income tax on the amount withdrawn.

Annual Contribution Limits

For 2024, the limit is $4,150 for individuals and $8,300 for family coverage for families. For 2025, those amounts are $4,300 and $8,600, respectively. There is also an additional $1,000 catch-up contribution available for anyone age 55 or older by the end of the tax year who has not enrolled in Medicare.

Advantages of HSAs

Access to an HSA is intended to take some of the stress out of unexpected health costs. These accounts also have several other advantages.

Many Expenses Qualify

Eligible expenses include a wide range of medical, dental, and mental health services. These are explained in detail in IRS Publication 502, Medical and Dental Expenses.

Note

Over-the-counter medications and menstrual products qualify as HSA expenses, thanks to the CARES Act of 2020.

Others Can Contribute

Contributions can come from you, your employer, a relative, or anyone else who wants to add to your HSA. Employers can choose whether or not to contribute to their employees’ accounts

Pretax Contributions

Contributions are made with pretax dollars through payroll deductions by your employer. In other words, your employer won’t withhold taxes on these dollars.

That means that the money is not included in your gross income and is not subject to federal income taxes. In most states, contributions are not subject to state income taxes.

Tax-Deductible After-Tax Contributions

If you make contributions with after-tax dollars, you can deduct the money from your gross income on your tax return, reducing your tax bill for the year. For example, if you’re an individual under the age of 55, your maximum allowed contribution to an HSA is $4,150 in 2024.

So, if you deposit only $2,600 into your HSA through payroll deductions by the end of 2024, you may choose to deposit an additional $1,550 to further lower your tax liability. You generally have until the IRS tax filing deadline to contribute.

Tax-Free Withdrawals

Withdrawals from your HSA are not subject to federal (and in most cases, state) taxes if you use them for qualified medical expenses.

There are also no required minimum distributions (unlike some retirement accounts). You should only take out money when you have healthcare costs and save the rest for future expenses.

Investment Options

The balance in an HSA can be invested. You can purchase stocks, bonds, and other types of assets to boost your potential returns. Most financial advisors will strongly suggest putting FSA funds in conservative investments such as U.S. Treasury bonds. This account is, first and foremost, a nest egg for unexpected medical expenses.

Tax-Free Earnings

Any interest or other earnings on the money in the account is tax free. While most HSAs earn a minimal amount of interest, generally less than 0.1%, the account can generate significant returns from investments.

Annual Rollover

If you have money left in your HSA at the end of the year, it rolls over to the next year.

This is a big advantage over FSAs, which normally can only be carried for 2½ months into the following plan year. For 2024, you could only carry forward up to $640 in an FSA.

Portability

The money in your HSA remains available for future qualified medical expenses even if you change health insurance plans, leave for a different employer, or retire.

Essentially, your HSA is a bank account in your name, and you decide how and when to use the funds.

Note

HDHPs are required to set a minimum deductible and a maximum for out-of-pocket costs.

• In 2024, the deductible must be at least $1,600 for an individual and $3,200 for a family while out-of-pocket costs are limited to $8,050 for individuals and $16,100 for families.

Convenience

Many HSAs issue a debit card so you can pay for prescription medications and other eligible expenses. If you are waiting for a bill to come in the mail, you can call the billing center and make a payment over the phone using your HSA debit card. You can also reimburse yourself out of an HSA if you have paid a medical bill with another form of payment.

Disadvantages of HSAs

If you qualify for an HSA, there are some disadvantages to consider.

High-Deductible Requirement

An HDHP, which you are required to have to qualify for an HSA, can put a greater financial burden on you than other types of health insurance. Even though you will pay less in premiums each month, 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.

This is something to consider for anyone who knows they will have hefty medical bills in a particular plan year.

Warning

The deductibles for HDHPs are often significantly higher than the minimums required and can be as high as the maximum out-of-pocket costs allowed.

Pressure to Save

Some people may be reluctant to seek healthcare when they need it because they don’t want to spend the money in their HSA accounts.

Cash Requirements

People who fund their own HSAs should be able to afford setting funds to cover a significant portion of their HDHPs’ deductibles in case they encounter unexpected medical bills.

Taxes and Penalties

If you withdraw funds for non-qualified expenses before you turn age 65, you’ll owe income taxes on the money plus a 20% penalty. Once you’re 65, you’ll still owe taxes but there is no penalty.

This can be hard on a person who faces an unexpected expense that is anything but medical. They have saved the money but can’t access it without taking a financial hit.

Recordkeeping

HSAs also come with regulatory filing requirements regarding contributions, specific rules on withdrawals, distribution reporting, and other factors. This can create a record-keeping burden (unless your HSA provider takes care of the paperwork). Even so, you must keep receipts to prove that your withdrawals were used for qualified health expenses. This will be necessary if you are audited by the IRS.

Fees

Some HSAs charge a monthly maintenance fee or a per-transaction fee, which varies by institution. While typically not very high, the fees are almost certainly higher than any interest that the account may earn, so they will cut into your bottom line.

Sometimes these fees are waived if you maintain a certain minimum balance.

Planning Challenges

Budgeting for next year’s medical expenses is often difficult. Obtaining accurate information about healthcare costs can sometimes be challenging, The timing and likelihood of Illness can also be unpredictable. An HSA can help you prepare to some degree, but you cannot always forecast major bills in the coming year, so you might find yourself with large, unexpected expenses.

What Is the Main Benefit of a Health Savings Account (HSA)?

Having a health savings account alleviates some of the stress of unexpected medical expenses. The money you save in this account is tax-free. You can claim a deduction on your tax return for your HSA contributions regardless of whether you itemize deductions. You can claim a tax deduction even if someone other than your employer makes a contribution to your HSA. If your employer contributes to your HSA, these contributions are excluded from your gross income. You do not even pay taxes on the earnings and interest you receive from the assets you hold in your HSA.

What Is the Main Downside of an HSA?

The main downside of an HSA is that you must have a high-deductible health insurance plan to get one. A health insurance deductible is the amount of money you must pay out of pocket each year before your insurance plan benefits begin.

You will be responsible for coming up with the cash to pay for your deductible before your insurance plan begins paying your healthcare costs. You’ll need to pay for visits to the doctor, medical procedures, and prescriptions until you satisfy your deductible.

In 2024, you’ll need to pay a deductible of at least $1,600 for an individual and $3,200 for a family.

What Are the Benefits of a High-Deductible Insurance Plan With an HSA?

The main benefits of a high-deductible medical plan with an HSA are tax savings, the ability to cover some expenses that your insurance doesn’t, the ability to have others contribute to your account, and the convenience of using the account to pay for healthcare expenses.

Another benefit of an HSA is the portability of the account. You roll over any funds left in your account at the end of the year to the following year. The money is yours forever. You can simply allow it to grow in your HSA. Some people use their HSA as part of their retirement planning strategy.

Are Employers Required To Contribute to an HSA?

No, employers who offer HSA plans to their employees have the option of contributing or not contributing. Still, most employers do provide funds for their staff members.

How Can I Check the Balance on My HSA?

Most financial institutions that provide HSAs offer their customers various ways to check their account balances. These include:

1. Online access: Your HSA provider will give you access to your account online, and you can log in just as you would for an online bank or brokerage service.
2. Printed statement: Your balance and recent transactions can be included in your printed statement.
3. Phone app: Check to see if your HSA provider offers an app that allows you to check your account balance from your phone.
4. Customer service: Your HSA provider will have a customer service number that you can call for assistance.

Should You Invest Your HSA Funds?

An HSA offers a number of advantages over traditional accounts for investment. Your contributions are tax-free; your gains are tax-free; there is no required minimum distribution; and any distributions for eligible medical expenses are not taxed.

The Bottom Line

For those who choose high-deductible health plans (HDHPs), an HSA has real advantages. It can offset your medical costs, reduce your taxes, and give you a long-term tax-advantaged savings account. An HDHP isn’t the best option for everyone, but having one is the only way to get access to an HSA account.

Read the original article on Investopedia.