What is a Health Savings Account and How Does it Work?

Russell W. Hall, CFP®

If you’re starting a new job or just evaluating your employee benefits, it’s possible you might see the option to open a Health Savings Account (HSA). It’s easy to ignore this option or to confuse it with a Flexible Spending Account, but you might want to take a closer look – especially if you are younger and relatively healthy.

The basics

HSAs were created in 2003 as a way for individuals with a High-Deductible Healthcare Plan (HDHP) to pay for medical expenses with tax-free money, when they would have otherwise had to pay those out of pocket with after-tax funds. In 2020, a plan must have a deductible of $1,350 for an individual and $2,700 for a family to qualify as a HDHP.

In practice, the HSA functions much like an IRA. You get a tax deduction for making contributions, and the account grows without being taxed. However, there is a key difference that makes the HSA “triple tax free” – any payouts that are spent on qualified medical expenses are not taxed. This can be hugely valuable, especially if you likely won’t need to spend the HSA money for a long time and can let it grow (more on that later).

This may sound obvious, but to open a HSA you can’t be covered by any other health plan. That would include your spouse’s health plan through work, or any Medicare plan.

More details

Unlike IRAs, HSAs are not subject to the 60-day rollover rule and there are no limits on rollovers. In theory, you could transfer HSA money between accounts at any time.

There are also no required minimum distributions (RMDs) for HSAs, while IRA account owners must take RMDs starting at 72. You don’t need to use the funds until you need them for qualified medical expenses, even well into retirement.  But funds in the HSA should be completely spent on medical expenses during the lifetime of the participant (and their spouse, if applicable). That’s because a non-spouse beneficiary like a child would need to withdraw the funds immediately, and the full value would be taxable.

This year, individuals can contribute $3,550 and families can put in $7,100. There is also an additional $1,000 catch up contribution if you’re over 55. The contribution deadline is normally April 15, just like with IRA and Roth IRA accounts.

Other benefits

HSAs are portable, meaning that they are not tied to the employer that the account was opened with. But if you change jobs, you can only continue contributing to the HSA if you’re still covered under a HDHP plan. Otherwise you can keep the money in the HSA until you spend it, but can’t add to it. When you need to use HSA funds for qualified medical expenses, most providers will issue a debit card (similar to a Flexible Spending Account). You can also request reimbursements for expenses you paid previously, as long as they were incurred after you opened the HSA account. In that case, you’ll want to keep very good records and copies of receipts.

Some HSA providers allow participants to open Health Savings Brokerage Accounts and transfer part of their balances to be invested. As mentioned previously, we see this as a great option for younger healthy individuals who may already saving as much as they can to IRA or 401(k) accounts. The Brokerage option gives access to a wider range of investments, and that plus a long period of time for the money to grow can be a winning combination, providing a good amount of tax-free money to pay higher medical expenses later in retirement.

Is it for you?

If you are thinking about using a HSA, first make sure that your health care plan meets the high-deductible requirements. More and more employer-sponsored plans are offering a HDHP option, and self-employed individuals can often take advantage of a HSA.

You’ll also want to be aware of the higher deductibles on your HDHP plan and make sure that you can cover those medical costs out of pocket if something happens. Those who are not in great health or who are taking a lot of medication might not be good candidates for a HDHP and HSA.

However, if you’re in relatively good health and can afford to save for future medical expenses, we think the HSA can be a great option to use triple tax-free dollars. That kind of opportunity is rare in the US tax code!

If you have additional questions about HSAs, we can help. Schedule a 15-minute discovery call with a fee-only financial advisor.