A Health Savings Account (HSA) is a tax-free savings account you can open to help you with out-of-pocket healthcare costs.
Healthcare is expensive. Even with a comprehensive health plan, you still have fees and payments to meet if you need to see a doctor. An HSA allows you and your employer to save up for health-related costs on a pre-tax basis.
The advantage is if you don’t use all the money saved, it can also work as savings for retirement. You can withdraw them with no tax penalty after you retire.
Sounds great right? Well, there’s a catch. Not all healthcare plans are eligible for an HSA. It’s also not a substitute for health insurance. There are also contribution limits and restrictions on what you can spend the money on.
Read on to find out if it is good for your situation and how to qualify for one.
- Alternatives to an HSA
- Why It’s Great For Your Tax Returns
- Eligibility Criteria
- What Can You Spend Your HSA On?
- Should You Get An HSA?
Alternatives to an HSA
Let’s first define what a Health Savings Account isn’t.
It’s not a form of healthcare insurance. It’s not an alternative to the different healthcare plans your employer offers.
An HSA is similar to something else you may have heard of: a Health Reimbursement Arrangement (HRA).
This can be offered by your employer-based healthcare plan. It serves the same purpose as an HSA but with one big difference. While an HSA is funded by both you and your employer and is owned by you, an HRA is funded by just your employer and they own it.
If you change jobs you can take your HSA with you, but not an HRA.
Some also confuse an HSA with a Flexible Spending Account (FSA). We have a great article on the differences between the two here.
It’s a savings and investment account which you can deposit money, grow by investments and withdraw from, all tax-free. Let’s talk about that for a minute.
Why It’s Great for Your Tax Returns
An HSA is like supercharged IRA with three tax benefits.
1. Your contributions are tax-deductible
2. Your interest and dividends gains are tax-deferred
3. You can withdraw from it without paying tax on qualified medical expenses.
A further advantage? Many employer-based HSA plans have employer contributions. You get more tax free money to help with your health expenses and retirement.
It’s not a surprise then that HSAs are growing in popularity. While their main benefit is in helping with people’s health care costs, they’re also very useful in reducing your tax burden.
Your income is taxed after you make HSA contributions, which means you’re taxed like you have a lower income. This can be useful if you’re on the verge of entering a higher income tax bracket.
For instance, if you make $41,000 a year, by contributing $3000 to an HSA by payroll deduction, you’ll have a taxable income of $38,000. This way you avoid the 22% federal income tax bracket.
Also, if you open your HSA account with a financial institution that offers mutual funds it can be a great tax strategy to invest for your retirement.
Like an IRA, if your employer offers an HSA, the likelihood is they’ll help contribute towards it. This means you’ll get more tax-free money to spend on healthcare or for retirement.
For 2019 the maximum contributions you can make to an HSA as an individual are $3500 in a year, and $7000 as a family. It’s recommended to match these limits to maximise your tax savings.
Not everyone is eligible for an HSA. In order to qualify for an HSA, your health care plan has to be what the IRS calls a high-deductible health insurance plan (HDHP). This means that your health care plan has to be a plan with certain minimum deductibles and out-of-pocket expenses.
If you’re not eligible for an HSA you may be able to use an FSA which we mentioned earlier. However, there are limitations. Unlike an HSA you can’t roll over the money you put into an FSA – it has to be spent before the year is out.
Confused by all the terms we just threw at you in the past 2 paragraphs? Healthcare jargon can be confusing at first, but is quite simple when it’s broken down. Before we move on and tell you the eligibility criteria, let’s explain a few terms. Feel free to skip if you know it already.
Quick Jargon Buster
Car insurance is simple. Every month you pay some money to your insurer. If you don’t pay you will lose your insurance coverage. If you get into a car accident, you pay a little bit of money towards the repairs, and the insurance pays the rest.
Health insurance is a bit different. You pay money every month for coverage, just like car insurance. When you visit the hospital you also pay a bit of money towards the bills before insurance covers the rest. However, you also pay a little bit extra on top for each and every visit.
Unlike car accidents which are a matter of if, health care is a matter of when. It’s only a matter of time until you need to visit the doctor, and that’s why it’s different from other insurance markets.
- Deductible: This is what you pay upfront for your medical care before your insurer’s coverage kicks in. Once you meet your deductible your insurer covers a large part of the bill. It resets every year.
- Premium: This is what you pay every month to have health insurance whether you use it or not.
- Co-payments: Predetermined rate you pay to access healthcare services. With your plan, you could have to pay $20 every time you go to the doctor’s office or a $10 copay for your monthly medication.
- Coinsurance: Once you meet your deductible, your health insurer takes up the bulk of your medical bills. But not all of it. Your co-insurance is the percentage of a medical bill you pay for after you meet your deductible. For instance, with a 15% coinsurance, you would pay 15% of each medical bill, and your health insurance provider will cover the remaining 85%.
- Out-of-pocket maximum: But you can’t just keep paying for your healthcare. Otherwise in a bad health year even with the best plan you would become bankrupt. Your out of pocket limit is the absolute maximum you would need to pay for your healthcare in a year before your health provider covers 100% of the bill.
If you have a high-deductible health plan your medical bill can be quite steep before it reaches the point your health insurance provider will cover 100% of your costs. This is where an HSA comes in. It encourages you to stash a rainy day fund only to be used for medical expenses.
With that detour out of the way, let’s go back to what makes your healthcare plan eligible for an HSA.
Back to eligibility
HSAs are available with employer-based healthcare plans. You can get one if you’re self-employed as well. You can also get an HSA with some Affordable Care Act plans.
HSAs are only offered with healthcare plans that have low premiums and high deductibles. These are known as HDHP plans. IRS guidelines for 2019 state that an HDHP plan has to have a minimum deductible of $1350 a year and an out-of-pocket maximum of $6750 for individuals. For families, the figures rise to $2700 and $13500 respectively.
You can’t contribute to an HSA if you’re enrolled in either Medicare part A and/or B.
For more information on if you qualify for an HSA check out IRS publication 969.
What Can You Spend Your HSA On?
There are limits on what you can use your HSA funds on. The point of an HSA is to only be spent on qualified medical expenses. As well as for your deductibles, coinsurance, and copays, it can be spent on general medical expenses like:
- Prescription drugs
- Long-term care
- Hearing aids
- Breast Pumps
- Stop smoking programs
You cannot spend your HSA on your health insurance premiums. There are exceptions to this rule, but it’s best to find out from a tax advisor.
You can find examples of what you can spend your HSA on and not on in IRS publication 502. If in doubt it’s best to talk to a tax advisor. For example, you can’t use your HSA on cosmetic surgery or your health club bills, though some would assume they qualify as medical expenses.
Some HSA accounts provide you with a debit card which will only work on qualified medical expenses.
Should You Get An HSA?
Things like your flexibility in contributing, the ability to keep your unused balance and additional tax benefits make HSAs the wisest choice. So sign up for an HSA – it’s free →
Disclaimer: the content presented in this article are for informational purposes only, and is not, and must not be considered tax, investment, legal, accounting or financial planning advice, nor a recommendation as to a specific course of action. Investors should consult all available information, including fund prospectuses, and consult with appropriate tax, investment, accounting, legal, and accounting professionals, as appropriate, before making any investment or utilizing any financial planning strategy.