What is a health savings account?

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A health savings account, or HSA, is a great tool that lets people sock away tax-free money to pay out-of-pocket medical costs. And there is no deadline to use it or lose it, unlike a flexible spending account. You can use the HSA funds later to help pay medical expenses in retirement.

The hitch is you’ve got to have a high-deductible health insurance plan that qualifies for an HSA.

Here’s what else you need to know about health savings accounts.

How can you get an HSA?

To qualify for an HSA, you must be enrolled in a high-deductible health insurance plan and have no other health insurance. You cannot be claimed as a dependent on someone else’s tax return and you cannot be eligible for Medicare.

The IRS sets the thresholds for what is considered a high-deductible health plan. For 2020, a qualifying insurance plan has a deductible of at least $1,400 for an individual or $2,800 for a family.

Not all plans with a high deductible are eligible, so when shopping for an HSA look for plans that say “HSA-eligible.” Your employer may offer HSA-eligible insurance plans.

You can also find financial institutions that offer these accounts. BMO Harris Bank and State Farm Bank offer HSAs, for example. Applying for an HSA at a bank is similar to opening a savings account. You must fill out an application and provide basic information, such as your Social Security number, date of birth, physical address, phone number and a valid email address.

You can use HealthCare.gov to find HSA-eligible plans and websites like HSASearch to compare providers.

How do HSAs work?

Once you have an HSA, you can decide how much you want to contribute each year, up to the limits set by the Internal Revenue Service. If you have an HSA through your employer, you can set up automatic contributions to the account from your paycheck.

Unlike flexible spending accounts, HSA funds roll over year after year. Any money you put into your HSA stays there until you use it. There are no required minimum distributions or rules about when you have to make withdrawals. HSAs generally come with a debit card or checks, which makes paying for medical expenses easy and straightforward.

HSAs can be used to pay out-of-pocket expenses such as co-pays and deductibles, but they usually cannot be used to pay insurance premiums. The federal government sets the ceilings for out-of-pocket medical expenses. For 2020, the most an insured individual can be required to pay out of pocket is $6,900; the ceiling is $13,800 for a family. Once the insured party has met the out-of-pocket maximum, the insurance company must cover the rest.

HSAs are also portable. If you change jobs or health insurance plans, your HSA goes with you.

If you are 65 or older and enrolled in Medicare, you can no longer make contributions to an HSA, but you can still use the money you’ve built up in the account to pay out-of-pocket medical expenses.

What happens to your HSA if you die?

You’ll be asked to designate a beneficiary of your HSA when you sign up. If you’re married, your spouse would inherit the money tax-free upon your death. For any other beneficiary, the account will no longer be a HSA and the beneficiary would be taxed on the value of the account in the year in which you died.

The IRS says married couples cannot have a joint HSA, even if they are covered by the same high-deductible insurance. But each spouse who qualifies can have his or her own HSA and use distributions to cover the qualified expenses of the other spouse.

What are the advantages of an HSA?

There are a number of benefits to an HSA, with tax perks being among the most significant:

  • Contributions to an HSA are tax-deductible, or pre-tax if made through a payroll deduction. This means they are not included in your annual gross income and are not subject to federal income taxes.
  • Interest earned on the account is tax-free.
  • Withdrawals are tax-free as long as they’re used to cover qualified medical expenses.
  • You can use the funds in your tax-advantaged accounts now and in your retirement years.
  • You, an employer, a relative or others can contribute to your HSA.
  • There are no time constraints for spending the funds. If you have money left in your HSA at the end of the year, it rolls over so you can use it the following year.
  • Your HSA is portable, so even if you change employers or insurance companies, you can still use the funds for qualified medical expenses.
  • The list of medical expenses that qualify for HSA spending is extensive — everything from eyeglasses and hearing aids to bandages and birth control pills.
  • HSAs can be invested in mutual funds, stocks and other investment products.

“One of the great things about an HSA is you don’t have time limits on the distributions,” says Juli Erhart-Graves, certified financial planner and president of Worley Erhart-Graves in Indianapolis.

So, you could pay for qualified medical expenses out of your cash flow each year but still make the maximum contribution to your HSA — potentially building up money in the account for use in future years.

“It’s important that you have the receipts to match up to a distribution, but this gives you a tax-free distribution, which can be very helpful in retirement years,” Erhart-Graves says.

What are the disadvantages of an HSA?

The main disadvantage of an HSA is that it’s limited in how you can use it. Other drawbacks:

  • If HSA funds are used for anything other than qualifying medical expenses, you’ll owe taxes on that money, plus a 20 percent tax penalty. After age 65, you’ll owe the taxes but not the penalty.
  • Some HSA providers charge account fees, such as monthly fees or per-transaction fees. You may be charged for account overdrafts or deposits that don’t clear. Ask the HSA custodian for a complete fee schedule.
  • You must be enrolled in a health insurance plan with a high deductible to qualify for an HSA.

What happens to your HSA if you change insurance or jobs?

HSAs are portable accounts. So, if you switch insurance, change jobs or retire, you’ll still have access to your HSA. “It’s yours. You can move it to a different bank or custodian if you want,” Erhart-Graves says.

If you no longer have medical insurance that qualifies for an HSA, your existing HSA sits there until you use it, move it or invest it, Erhart-Graves says.

How much should you contribute to your HSA?

Your contribution to your HSA depends on your personal financial situation. Ideally, you would contribute the maximum allowed each year by the IRS, says Erhart-Graves.

In 2020, the maximum allowable HSA contribution is $3,550 for individuals and $7,100 for families. If you are 55 or older at the end of the tax year, you can contribute an additional $1,000.

If you can’t afford to contribute the maximum, try to contribute the amount you expect to pay for qualified medical expenses for the year. “Since you have to pay the medical expenses anyway, send them through the HSA so you don’t have to pay taxes on those amounts,” Erhart-Graves says.

Can you invest HSA funds?

All or part of the funds in health savings accounts can be invested in mutual funds, stocks, bonds and other investment products. It’s a tax-free way to grow your HSA to pay for medical expenses in retirement. But investing in risky products such as these may mean that your money is not there when you need to pay for a service. Fortunately, you can also put your money into safe but lower-yielding investments such as a money market fund.

The choice of HSA investment tools differs among plan custodians. Some HSAs are merely savings accounts that do not earn much interest. Shop around for a plan with quality investment options and low costs.

Remember, though, that FDIC-insured savings accounts are protected up to $250,000, but stocks and other investments do not have that safeguard.

Bottom line

Health savings accounts are beneficial for people with high-deductible health insurance plans. They have several tax benefits and can be invested and grown to help pay medical expenses in retirement.

Featured image by Money Business Images of Shutterstock.  

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Written by
Libby Wells
Contributing writer
Libby Wells covers banking and deposit products. She has more than 30 years’ experience as a writer and editor for newspapers, magazines and online publications.
Edited by
Banking editor