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The Definitive Guide to Health Savings Accounts and How They Work

This guide covers everything financial experts have to say about getting a health savings account, and using it effectively to save for medical expenses and reduce your taxable income.

Health care costs for Americans have been skyrocketing. According to projections by the Peter G. Peterson Foundation, total health care spending in the U.S. is forecasted to increase by 5.6% annually for the next decade — faster than the country’s economy.

A Health Savings Account (HSA) can help you plan for and beat the rising costs. HSAs offer some of the greatest tax advantages for both individuals and families who have a high-deductible health plan (HDHP). It can lower your costs for eligible medical expenses right now and can also be used to save for future health care costs and even retirement.

If you have an HDHP or plan to enroll in one, it’s important to understand what an HSA is and how it can help you save big.

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What is an HSA?

An HSA is a tax-exempt financial account that you can use to save for and cover the cost of eligible medical expenses.

With an HSA, you can set aside money earmarked specifically for health care costs, then deduct those contributions from your income on your tax return. The funds in your HSA also grow tax-free, and you can use them on a tax-free basis to pay for eligible medical expenses.

If you have an HDHP through your employer, you may be able to open an HSA through an employer-chosen partner. Some employers even offer to help contribute to employees’ HSAs as a benefit, similar to a 401(k).

HSAs are portable accounts, which means that you don’t have to worry about losing your money when you switch jobs like you would with a Flexible Spending Account (FSA). You can also have an HSA through your employer and separate one that you open on your own.

If you qualify, an HSA is an easy and smart way to pay for qualified medical expenses for you and your dependents.

With its tax-advantages, easy access to savings, and growth potential, it’s an effective savings vehicle that provides benefits today and in the future.

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Account Eligibility

There are two components to HSA eligibility: whether you can open or contribute to an HSA at all and how much you can contribute each year.

Health Plan Requirements

To qualify for an HSA, you need to have a specific type of health insurance plan known as a high-deductible health plan. HDHPs have lower premiums than comparable plans with lower deductibles, making them a good option for people who don’t anticipate having a lot of medical expenses or simply want to save on monthly payments.

Even if you expect to spend thousands of dollars on health care costs, the benefit of an HSA may be worth it to choose an HDHP over a plan with a lower deductible.

Based on 2021 IRS specifications, a health plan is an HDHP (and qualifies for an HSA) if it has a minimum deductible of $1,400 for individuals and $2,800 for family plans. Qualifying plans must also have maximum out-of-pocket amounts of less than $7,000 for individuals and $14,000 for families.

It’s important to keep in mind that with an HDHP, you generally pay more up front for medical expenses before the plan begins to pay for covered services. Most of these plans cover preventive care like a physical exam with zero out-of-pocket costs, but you might have to pay in full for other doctor visits, prescription drugs, and more. Beyond that, an HSA-eligible health plan is much like a traditional health care plan.

The good news is that HSAs don’t have income limits, which means anyone can use one and get the tax benefits. For more information on if you qualify for an HSA, check out IRS publication 969.

Contribution Limits

To take full advantage of tax savings and to build a reserve for the future, it’s suggested that you save as much as possible in your HSA. However, like other tax-advantaged financial accounts, such as Flexible Spending Accounts, 401(k)s, and individual retirement accounts (IRAs), there are limits to how much you can save with an HSA each year.

The 2021 contribution limits set by the IRS are $3,600 if you have an individual health plan and $7,200 if you have a family health plan. If you’re 55 or older, you can make catch-up contributions of up to $1,000 on top of the regular limit each year.

If you become eligible for an HSA on or before December 1 of the current year, you qualify for the full annual contribution limit. If it’s December 2 or later, though, you’ll only be eligible for a prorated amount under the last month rule.

Keep in mind that while you can have multiple HSAs, the contribution limits apply across all of your accounts, not for each one individually.

If you’re not sure how much you can contribute, you can use Lively’s HSA eligibility calculator to find out. It algorithmically calculates hundreds of HSA contribution scenarios to show you exactly how much you can contribute.

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How to Use an HSA

There are a few different aspects of using an HSA that are important to know. Here’s what you need to know about each.

Contributing

There are five different types of contributions that can be made to an HSA. Here’s what to know about each one:

  • Payroll deductions: If you have an HSA through your employer, you can request to have money deducted directly from your paycheck and contributed to your HSA on your behalf. Payroll deductions are beneficial because the money is automatically deducted before taxes.
  • Employer contributions: According to the Employee Benefit Research Institute, 46% of HSAs with contributions in 2018 received employer contributions, with an average benefit of $901. These contributions also aren’t taxed, but you’ll want to make sure you know how much your employer is putting in your account because the annual contribution limit includes all contributions, not just what you put in the account.
  • Individual recurring contribution: If you don’t have an employer-sponsored HSA, you can set up an automatic transfer from your checking or savings account each month. Setting up a recurring contribution can help you maximize your savings because you don’t have to remember to do it manually every month.
  • Individual one-time contribution: With this option, you can transfer money from your bank account manually or, in some cases, mail a check to the provider. This might be a good option if you have a big medical expense coming up and want to make sure you get all the tax benefits you can. If you also have recurring contributions, though, be sure to adjust those to make sure you don’t go over the limit.
  • Third-party contributions: Anyone can contribute to your HSA on your behalf, including family members, friends, or anyone else. What’s more, you can deduct those contributions on your tax return even though you weren’t the one who made them.

One thing to note is that in every case outside of payroll and employer contributions, you or someone else is contributing money that’s already been taxed. But they are tax-deductible, and you’ll be able to enjoy the savings when you file your return for the year.

Distributing

There’s no time limit for when you can use the money in your HSA to pay for eligible medical expenses — it’s not a use-it-or-lose-it arrangement like a Flexible Spending Account.

When you’re ready to use the money, however, you’ll typically have two options. The first is to use a debit card that’s tied to your HSA. When you first opened your account, most providers send a debit card for convenience.

The other option is to pay the bill on your own and request a reimbursement from your HSA provider. In this scenario, you’ll typically need to provide a receipt to prove that the transaction was eligible.

Saving (for Retirement)

If you don’t have enough eligible health care costs, you can save any money you or someone else has contributed to your HSA until you need it. Some people may even choose to use an HSA as a retirement account, where health care costs can make up a significant portion of your budget.

Investing

Most Health Savings Accounts function like a traditional savings account — your funds earn a nominal interest rate that’s equivalent to what you’d earn if you put the money in savings with your bank or credit union.

Investing your HSA funds can be especially worthwhile if you’re planning to save the money for retirement.

Investing your HSA funds can be especially worthwhile if you’re planning to save the money for retirement. With a long-term goal, the short-term fluctuations of the stock market won’t have as much of an impact on you. However, if you anticipate using your HSA funds in the same year that you contribute them, you may be better off keeping the money safe with the lower and safer savings rate.

What Can Account Funds Be Used For?

One of the most important things to know about Health Savings Accounts is that the tax benefits work only if you use your funds for eligible expenses. If you don’t, your withdrawals will be taxed as income, and you’ll also be subject to a 20% additional tax.

The only exception is that if you become disabled, die, or reach age 65, you can use HSA funds for non-medical expenses without incurring the 20% additional tax. However, those funds will be considered taxable income.

Medical Expenses

The IRS provides a long list of eligible medical expenses that you can cover with your HSA funds. These costs generally include payment to doctors, hospitals, and other health care providers, over-the-counter and prescription drugs, imaging such as MRIs, medical services such as home care, and medical equipment or supplies.

If you submitted a claim to your health insurance company and it didn’t cover the full amount, you can use your HSA funds to pay the remaining balance. Just keep in mind that you cannot request reimbursement from your HSA for costs covered by your insurance plan.

Knowing exactly what is and isn’t covered can be tricky. Lively created a free search engine to find out if what you want to buy is a qualified medical expense. You can also visit HSA Store to find and purchase thousands of eligible expenses.

Vision Care

While vision care is typically isn’t covered by a health insurance plan, you can use your HSA to pay for eligible vision-related expenses. That includes things like eye exams, eyeglasses and accessories, contact lenses and solution, eye drops, eye surgery, vision correction, and more.

The list even includes sunglasses if they have prescription lenses and you didn’t purchase them over the counter.

Dental Care

The IRS allows HSA holders to use their funds to pay for the prevention and alleviation of dental disease. Preventive treatment includes the services of a dental hygienist or dentist for such procedures as teeth cleaning, the application of sealants, and fluoride treatments to prevent tooth decay.

Treatment to alleviate dental disease includes the services of a dentist for procedures such as X-rays, fillings, braces, extractions, dentures, and other dental ailments.

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Benefits of an HSA

If you qualify for an HSA and can afford even small contributions, the benefits of an HSA are worth it. The biggest perk of having an HSA is the triple tax savings:

  • Pre-tax or tax-deductible contributions
  • Tax-free interest and investment earnings
  • Tax-free distributions, when used for qualified medical expenses

If you’re going to spend the money on health care costs anyway, contributing the cash to your HSA first will effectively reduce your total cost. For example, if you have an effective tax rate of 15% and you spend $5,000 on qualified medical expenses through an HSA, that’s $750 worth of tax savings.

HSAs are also portable, which means you always keep your HSA even if you change employers or stop working entirely. You also don’t have to worry about losing funds you don’t use in a given plan year, which is one of the potential drawbacks of an FSA.

If you don’t use funds, they remain in your HSA each year. They also continue to earn interest or investment gains and don’t have to pay taxes on it.

Finally, you can use your HSA to help power your retirement savings, along with an employer-sponsored retirement plan and an IRA. One key difference is that you won’t be forced to take required minimum distributions at age 72 like you would with a standard retirement account.

If you use HSA money in retirement to cover eligible expenses, it’ll still be tax-free. But if you use it for other purposes, you’ll just have to pay regular income taxes.

Account Comparisons

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Depending on your situation, you may have the option to choose between an HSA and an FSA, another account you can use to save for health-related expenses.

You might also be wondering if it’s worth it to go with an HDHP just to get an HSA or if you might be better off with a traditional health plan instead. Here are some comparisons to help you make the right decision.

HSA vs. FSA

While the two accounts are incredibly similar in terms of usage, they are regulated differently, depending on the type of account you have.

A Flex Spending Account or Flexible Spending Arrangement (FSA) is only available through an employer and you can only make contributions through payroll deductions. Each year during open enrollment, you’ll determine how much you want to contribute for the upcoming plan year.

Your employer will then deduct equal contributions from your paycheck the following year. For example, if you choose to contribute $1,200, that’s $100 per month in pre-tax contributions. That said, you’d have access to the full $1,200 balance at the beginning of the year.

With both an HSA and an FSA, you can pay for qualified medical expenses while lowering your taxable income.

The biggest difference between an FSA and an HSA is that once you contribute money to your FSA, you need to use that money by the end of the year, or else you forfeit it back to your employer, who can then opt to use it to offset the costs of administering benefits or split it among employee contributions.

According to the IRS, an employer that sponsors an FSA can allow its employees to roll over up to $500 of their unused FSA funds to the next plan year or allow them a grace period of up to two-and-a-half months to use their full remaining balance.

While this modification is helpful, this means that the money that you contribute to your FSA doesn’t stay yours.

In general, you can’t contribute to both an FSA and an HSA in the same year. The only exception is if you have a Limited Health Care FSA.

HDHP + HSA vs. HMO or PPO

A preferred provider organization (PPO) offers a network of health care providers that you can use for medical care but also cover you if you choose an out-of-network provider — though typically at a higher cost to you and with a separate deductible.

In contrast, a health maintenance organization (HMO) limits your network to providers that work for or contract with the HMO and typically won’t cover expenses incurred through out-of-network providers unless it’s a medical emergency. HMOs also require you to get a referral from your primary care physician if you want to get an appointment with a specialist.

However, the question isn’t whether an HSA is better than a PPO or HMO, but whether you want a health insurance plan with a high deductible or a low one. It is possible for PPO and HMO plans to also be HDHPs.

To determine whether an HDHP with an HSA is better than a health plan with a lower deductible, think about how much you typically spend on health care costs for you and your family each year. If it’s a lot and you don’t think you’ll be able to afford to pay everything out of pocket until you reach a high deductible, a lower-deductible plan may be the better choice.

But if you don’t spend a lot of money on medical expenses, or the tax savings from an HSA coupled with an HDHP is worth the additional out-of-pocket costs, that may be the better path for you.

Take some time to consider all of your options, and consider speaking with your human resources representative to get personalized advice for your situation.

How to Sign Up for an HSA

Open and FDIC-insured HSA in minutes with Lively. Lively brings HSA into the modern era, so it’s easier for you to keep health care costs low today and plan for the costs of tomorrow.

The account is 100% free, provides a simple, intuitive, and transparent process, and includes investment capabilities. You can sign up for an HSA with Lively.

Frequently asked questions
Is an HSA also health insurance?

No, an HSA is not a health insurance plan. Health insurance is provided by an insurance company, while HSA’s are often provided by employers through a banking partner. An HSA is a type of savings account to help you pay for eligible out-of-pocket expenses and eligible expenses not covered by your insurance plan. It will not be accepted as insurance by a health care provider.

Is an HSA tax-deductible?

Yes, contributions made to an HSA with after-tax money are tax-deductible. However, you’ll need to fill out the right HSA tax forms for your contributions to be deducted on your tax return each year.

Are HSA contributions pre-tax?

They can be! If you make HSA contributions through payroll deduction, they will be taken out on a pre-tax basis, and you won’t have to worry about deducting them on your tax return.

What happens if I use my money to pay for a non-qualified expense?

If you are under 65 years old, you will have to pay state and federal income tax as well as a 20% penalty for the amount you’re disbursed out of your HSA account.

If you are 65 or older, disabled, or die, then you will just pay ordinary income taxes with no penalty. If you find yourself in this situation, you can attempt to put money back into your HSA funds before tax time each year.

Does an HSA roll over?

Once funds are deposited into your HSA, the account can be used to pay for qualified medical expenses tax-free, even if you no longer have coverage through an HDHP — just note that you can no longer contribute to your HSA without being taxed.

The funds in your account roll over automatically each year and remain indefinitely until used. There is no time limit on using these funds. If you wish, you can also roll over your HSA funds between financial institutions that act as HSA providers.

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