How does a health savings account affect my taxes?
7 min read •
30 sec brief
An HSA offers three different tax benefits. This means that you will have to file additional paperwork with the IRS when you do your taxes. Here is some information on the things you will need to share.
Winning the lottery is the ultimate get rich quick fantasy. You may dream of ways to spend the money, even before hitting it big. Your new home, fancy car, trendy wardrobe, or luxury vacation may be top priorities—but not before the IRS takes their cut.
Earning money means the government wants their share, except when it comes to health savings accounts. These accounts offer triple tax benefits—making them the unicorn of the tax world.
If you have a high-deductible health insurance plan (HDHP), you are eligible to contribute to an HSA. Here's everything you need to know about health savings accounts and how they may affect your taxes.
How to save on taxes with a health savings account
While budgeting with a high deductible health plan may seem like a challenge, partnering them with health savings accounts (HSA) can ease that burden. HSAs help those with HDHPs by offering them three specific tax savings:
1. Health savings account funds are contributed pre-tax.
When you contribute to your HSA, the money goes in before you pay taxes. A portion of your paycheck goes into your HSA and then you pay taxes on the rest of your income. This strategy lowers your taxable income. If you choose to contribute to your HSA post-tax, those contributions are tax deductible.
Note: Qualified medical expenses—which you may deduct on your tax return if you itemize deductions and exceed 10 percent of your adjusted gross income—are different than HSA contributions. HSA contributions are an adjustment to gross income and are always allowed, whether you choose to itemize or not.
2. Health savings account investments grow tax-free.
One of the perks of your health savings account is the balance carries over from year to year. This offers the unique opportunity to grow your money for the future. Another perk of the HSA is that you can invest the funds within your account without paying taxes - even for the invested portion! Many HSA providers partner with investing partners so you can easily manage your funds in one place.
3. Health savings account withdrawals for qualified medical expenses are tax-free.
As long as you withdraw the money for qualified medical expenses, you won’t have to pay federal income tax on your earnings. This is different from a brokerage account, where you may owe capital gains tax.
Note: This applies to federal income taxes only. Every state treats health savings accounts differently, so it’s important to check your state tax laws regarding the matter.
These breaks may offer a significant amount of income tax savings. Let's say you're a single taxpayer earning $100,000 per year. If you contribute the maximum amount to your HSA, you could save $840 on income taxes for the year. Couples earning $100,000 and contributing to the limit may save $1,500 on federal taxes each year.
The exact amount of savings depends on your income, tax brackets, family size, and HSA contributions. Either way, your health savings account could lead to major income tax savings, and these tax benefits may add up to thousands of dollars over the course of your lifetime.
The downsides of a health savings account
HSAs may seem too good to be true. The problem is, not everyone has the right type of health care plan to qualify. You must have an eligible high-deductible health plan (HDHP) to contribute to your HSA, and once you apply for Medicare at 65, you will no longer be eligible to contribute.
You may score lower monthly insurance premiums with a high-deductible health plan. But your deductible will be higher than other plans—at least $1,400 for individuals and $2,800 for family coverage in 2020.
HSAs offer the opportunity to save money for healthcare expenses in retirement. The low annual contribution limit could make it difficult to build a large nest egg, which is why it shouldn’t be your only retirement account. For the 2020 tax year, the annual HSA contribution limits are $3,550 for an eligible individual and $7,100 for a family. There's also a $1,000 catch-up contribution for folks 55 and older.
Instead, consider it like an individual retirement account (IRA). These plans also have lower contribution limits, but may still be an excellent supplement in retirement. You should talk to your financial advisor for in-depth retirement planning advice.
Another downside of a health savings account is you must use the money for qualified medical expenses. There are plenty of things that qualify—like visiting the doctor, going to the hospital, dental expenses, and medications. They can also be used for things such as eyeglasses, orthodontics, and acupuncture.
The final drawback is record-keeping. It’s important to save copies of your receipts for qualified medical expenses throughout the year. You will have to submit Form 8889 with your tax return for a record of your HSA contributions and withdrawals. Some of this will be available on your W-2 from your employer. You’ll also receive Form 1099-SA from your plan administrator. You can see the complete details at IRS Publication 969 here.
Should I open a health savings account (HSA) or flexible spending account (FSA)?
It's easy to get confused by the differences between HSAs and FSAs. These two medical savings accounts have a similar name but there are some key differences. You're more likely to see an FSA, especially if you work for a small business. If you do, here are some of the key characteristics to watch for.
- You don’t need a high-deductible health insurance plan for an FSA. To qualify for an HSA, you must have an eligible high-deductible health insurance plan (HDHP). Luckily, FSAs don't have the same strict eligibility rule.
- Your employer owns your FSA. You can't open an FSA without your employer, which isn't the case with an HSA. The downside of opening your own HSA is you won’t qualify for a tax deduction because your contributions will be after taxes.
- FSAs don’t allow you to maintain a balance from year to year. FSAs are more restrictive than HSAs. You can’t roll over tax-exempt money from year to year. Depending on your employer, you may have one of two options: roll over $500 or have a grace period of two and a half months to use the money.
- FSAs have a lower annual contribution limit. Another downside of FSAs is the lower annual contribution limit. On the plus side, this may make it easier to spend the money on qualified expenses before the deadline.
- Both FSAs and HSAs are different from an HRA. A Health Reimbursement Account (HRA) is a plan that reimburses employees for the out-of-pocket medical expenses (and sometimes their plan premiums) when they make qualified medical expenses. While you may be reimbursed for qualified expenses like an FSA or HSA, you are unable to manage those funds as you would with those accounts.
Take advantage of tax savings with an HSA.
If you choose to go with a high-deductible health plan, don't skip the opportunity to pair it with an HSA. Even if your company doesn't offer one, there are plenty of providers you can choose from. You can check major financial institutions or online options like Lively. Our plan stands out with no fees, competitive investment options, and a world-class user experience.
About the author
Kate Dore is a Nashville-based freelance personal finance writer and Candidate for Certified Financial Planner™ Certification. She teaches financial literacy with Junior Achievement and serves as Director of Public Relations for the Financial Planning Association of Middle Tennessee. Her work has been published in Business Insider, Financial Planning Magazine, and Simple Money Magazine.
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