In this article:
A health savings account (HSA) is a type of tax-advantaged account you can use to save for future medical expenses. Similar to how you can use an individual retirement account (IRA) to get a tax break while saving for retirement, an HSA allows you to make pre-tax contributions to an account you can draw from when you need it.
There are limitations on who can open and contribute to an HSA, and what counts as a qualified medical expense. But if you're eligible, an HSA can become an important part of your long-term financial plan.
How Does an HSA Work?
You can open an HSA with an organization that's qualified to serve as a trustee for the account, which includes some banks, credit unions and companies that also manage IRAs.
The process is similar to opening a checking account, and you may receive a debit card or checks linked to your HSA. You may also be able to invest the money depending on where you open an account—and you can transfer your HSA to a different trustee later.
An HSA is intended for qualified medical expenses, such as copayments and coinsurance. Qualified expenses also can include medicine, equipment and procedures, and generally align with the medical and dental expenses that qualify for an itemizable deduction. If your spouse or a dependent is in need, you may be able to use your HSA to pay for qualified expenses on their behalf.
Your contributions to the account may be tax-deductible, and you can withdraw the money tax-free for qualified expenses. However, if you use money from your HSA for a non-qualified expense, you'll have to include the withdrawal portion in your taxable income and pay an additional 20% penalty.
The penalty is waived if you're 65 or older, disabled or withdraw money from an account after the account holder passes. However, you still have to include those withdrawals in your taxable income if you don't use them for a qualified expense.
Your employer may offer a flexible spending account (FSA), which is similar to an HSA but has distinct differences. With an HSA, you own your savings, but FSA funds are tied to your employer and can disappear if you don't use them or if you leave your job.
Who Qualifies for an HSA?
There are limits on who can open an HSA and how much you can contribute to your account each year. The limits and amounts can change from one year to the next.
To qualify for an HSA:
- You need to have a high deductible health plan (HDHP), an insurance plan that has relatively lower premiums and a high deductible. In 2020, HDHPs have a deductible of $1,400 or higher for individual plans, or $2,800 or higher for family plans. You may be eligible if your spouse has a non-HDHP plan, as long as the plan doesn't cover you.
- You don't have additional health coverage, although there are exceptions for special types of coverage, such as disability, dental, vision and long-term care.
- You can't be enrolled in Medicare.
- No one can claim you as a dependent on their tax returns.
If you qualify, the contribution limit for 2020 is:
- $3,550 if you have an individual health insurance plan.
- $7,100 if you have family coverage.
- If you're 55 or older, your contribution limit increases by $1,000.
- If you earned less than the year's contribution limit from the job where you got health insurance or you're self-employed, you can't contribute more than you earned.
- Employer contributions count toward your annual limit.
Similar to an IRA, you can contribute to your HSA for the current year through the next year's tax deadline. The amounts are also prorated if you're only eligible for part of the year.
Or, if you're eligible on December 1, you could be considered eligible for the entire year if you remain eligible through December 1 of the following year. The "last-month rule" can be complicated, but you can speak with the company that will run your HSA to ensure you don't overcontribute and have to pay a penalty.
Benefits of an HSA
An HSA provides a triple tax benefit to individuals—a rarity, even among tax-advantaged accounts:
- You can take a federal income tax deduction for contributions to your HSA.
- You can earn tax-free interest or investment gains within your HSA.
- You can make a tax-free withdrawal if you use the money to pay for qualified medical expenses
If someone contributes to your HSA on your behalf, you may still be able to claim the deduction. And employer contributions are generally excluded from your income. However, the impact on your state taxes can vary, as some states may tax your HSA contributions or earnings.
Another benefit is that you don't have to use the funds in your HSA right away. If you have the funds to cover a medical expense, you can keep your money growing in an HSA, knowing that you can withdraw the money tax-free later. Keep your receipts as proof of having a qualified medical expense to match the withdrawal.
Additionally, some HSA providers give you the option of investing the money in your account. You could, therefore, treat the account as a long-term retirement account (for post-retirement medical expenses) with the benefit of tax-free withdrawals. However, you might not want to risk the money by investing it if you may need it for short-term medical bills.
What Are the Disadvantages of a Health Savings Account?
While an HSA can offer tax advantages, there are downsides to consider as well:
- You have to have an HDHP to qualify, which could lead to paying more for medical expenses compared with a low-deductible plan.
- If you need to withdraw the money for a non-qualified expense, you could wind up paying a steep 20% tax penalty in addition to income tax liability.
- Some HSA providers charge maintenance or transaction fees that can eat into your savings.
Can a Health Savings Account Affect Your Credit Score?
As with other checking, savings and investment accounts, an HSA won't directly impact your credit scores. Your credit report won't even include these accounts or their balances. But unpaid medical bills can wind up hurting your credit if they're sent to collections.
Having an HDHP could lower your monthly premiums (relative to a different plan), which may free up money to set aside in an HSA. The tax break from the contributions could also help your overall financial situation, making it less likely that you'll have a bill you can't afford.
If you can't afford a medical bill, you can try to negotiate it or ask your medical provider for a payment plan. You may want to consider these options even when you can afford the bill to save money and spread out the cost.
An Important Part of Your Emergency or Retirement Planning
It's almost a certainty that you, your spouse or a dependent will have a qualified medical expense at some point in the future. If you think an HDHP makes sense for your household, opening and contributing to an HSA offers tax-advantaged savings with only a few downsides.
Keep detailed records of all your qualifying expenses once you open your account, and if you need money from your HSA you can use it. Otherwise, you can use your HSA as an emergency fund, let the account accrue interest and use those receipts to tap the HSA later. Or, you can invest the funds and take advantage of the tax-free growth as part of your retirement plan.