How Does a Health Savings Account Work?

Credit Signs Team

Credit Signs Team

July 21, 2020  •  3 min read

A Health Savings Account (HSA) is a tax-advantaged account that allows you to put money aside for future medical expenses. If used correctly, these accounts can help you shave money off your income taxes, and save for critical out-of-pocket medical expenses. 

Who Is Eligible for an HSA?

To be eligible for an HSA, you need to be enrolled in a qualifying High Deductible Health Plan (HDHP). An HDHP is a health insurance plan that typically has a low premium and high deductible. So your monthly premium payments are cheaper, but it will cost you more money  when you go to the doctor. 

Since HDHPs often have high deductibles and more out-of-pocket expenses (due to the lower premium), HSAs exist to help you save money tax-free should you have to shell out for medical costs down the line. 

Each year, the Internal Revenue Service (IRS) determines which HDHP plans are “HSA-eligible.” The IRS describe HDHPs as insurance plans that have a “higher annual deductible than typical health plans.” You can find up-to-date criteria for eligible HDHPs on the IRS website

How Does a HSA Work?

If you’re eligible for an HSA, there are two ways you can contribute to your account. In some cases, you can enroll in an HSA through your employer, and they will contribute money pre-tax during the payroll process (like your 401(k) or insurance plan). If your employer doesn’t offer an HSA program, you can contribute to an account on your own. Just make sure to document your contributions so you can deduct them on your taxes. 

Once you fund an HSA, the account functions similarly to a conventional savings account, but with two major differences: 

  • You can only spend your HSA funds on eligible medical expenses.
  • You can invest your HSA funds and don’t have to pay taxes on any earnings.

When it comes to spending your HSA funds, you are given a special debit card or checkbook associated with the account. You use these to pay for any and all eligible medical expenses you have. Be aware: HSA funds can only be used for eligible medical expenses, and you will be charged a penalty fee (20%) and tax on any withdrawals that are found to be ineligible. 

Eligible expenses include dental and medical costs, including some cosmetic procedures that aren’t typically covered under a conventional insurance policy. You can learn more about what counts as an eligible medical expense on the IRS website

Do HSA Funds Rollover?

If you don’t spend all the funds deposited in your HSA, your total balance will rollover at the end of each year. Unlike a Flexible Spending Account (FSA) which limits the rollover amount, an HSA allows unlimited rollover year-after-year.

Allowing the funds to rollover means you can keep this money in the account until you need it. Additionally, if you have those funds invested, you can continue to accumulate returns on that allocation over time. 

At the age of 65 you can withdraw funds from your HSA without incurring a penalty, though you have to pay income tax on the amount you take out. Since many seniors also rely on Medicare—which doesn’t cover all medical expenses—having an HSA helps cover medical costs you encounter in retirement. 

What Are the Tax Advantages of an HSA?

Of the many tax advantages offered by HSAs, the most significant is the reduction in your taxable income. Contributions to HSAs are either made pre-tax (through your employer) or can be deducted from your taxes (if you contribute on your own). In both these scenarios, you are effectively lowering your taxable income, which can reduce your federal and state income taxes. 

Another tax-benefit of an HSA, is you aren’t required to pay taxes on any money your account earns from interest. Select HSAs also allow you to invest your savings in the stock market, and any returns you receive from those investments will not be taxed. 

Our Two Cents

If you’re eligible for an HSA, consider getting one if you can afford the extra contribution each month. Even if you don’t expect many medical expenses, HSAs are good vehicles for lowering your taxable income, amassing savings and investing in the future.