What is a Health Savings (HSA)?
A health savings account (HSA) is a bank account used for spending on personal health care.
HSA accounts are an attractive alternative to paying for medical costs out of pocket, because they carry tax benefits.
In order to qualify for an HSA account, you must be enrolled in a high-deductible health insurance plan.
Also, HSA account funds can only be used on qualified medical expenses as defined by the IRS.
An HSA account is distinct from a medical savings account.
The Tax Benefits of an HSA Account
A health savings account not only helps people put away money for future medical costs, but also lets them save money tax-efficiently.
The HSA has three distinct tax benefits.
- The ability to contribute to the account with pre-tax income
- The ability to invest account funds without incurring taxes on capital gains
- And the ability to make tax-free withdrawals from the account for qualified medical expenses
Key Benefit #1
Contributing pre-tax income to an HSA account means that money comes out of your paycheck and goes directly into an HSA account without the need to pay income taxes on it.
This has the effect of lowering your total taxable income. For example, if you have an annual salary of $50,000 and you contribute $3,000 to an HSA account, you have reduced your taxable income from $50,000 to $47,000 for the year.
There is a contribution limit to HSA accounts set by the IRS.
In 2019, the IRS set the contribution limit at $3,500 for individuals and $7,000 for families.
Individuals age 55 or older may contribute an additional $1,000 per year. The IRS adjusts the contribution limits annually.
Key Benefit #2
The second HSA tax benefit is the ability to invest the HSA account in financial assets without incurring tax liabilities on capital gains.
In a typical brokerage account, if you invest in an exchange-traded fund or stock and sell it at a profit, you owe taxes at the end of the year based on your net realized capital gains.
With an HSA account, you never have to pay taxes on investment gains.
Key Benefit #3
Finally, you can withdraw funds from the HSA account to pay for qualified medical expenses.
This is in contrast to other tax-advantaged savings accounts such as IRA accounts, which require you to pay taxes when you withdraw funds. If you withdraw funds before age 65 for expenses other than qualified medical expenses, you must pay all of the taxes on income and capital gains, and an additional 20 percent tax penalty.
After age 65, you can avoid the 20 percent tax penalty, but you must still pay relevant income and capital gains taxes if you use HSA funds for non-covered expenses.
Health Savings Accounts vs. Flexible Spending Accounts
People covered by high-deductible health insurance plans are often given a choice between using a health savings account (HSA) or a flexible spending account (FSA).
Both accounts are used for medical expenses, but they work very differently.
The biggest difference between the two account types is that you can keep the contributions you make to an HSA and can grow the HSA account by investing it.
FSA accounts are typically on a “use it or lose it” basis—if you don’t spend the money in your FSA account by the end of the year, you lose the remaining balance and have to start over the following year.
The table below summarizes the key differences between the two accounts.