What Is an HSA and How Does It Work?

A Health Savings Account, or HSA, is an amazing tool that offers a host of benefits — and they’re not all related to healthcare. Getting a health savings account could help you save money at multiple points in your lifetime, but they’re not for everyone. 

HSAs allow you to set aside pretax money in a savings account specifically for healthcare-related expenses. That means doctors’ copays, prescriptions, and other qualified medical expenses. Withdrawals are tax-free as well, and many people use health savings accounts as vehicles for retirement. 

The main qualification to get it is to have a high-deductible health plan (HDHP). Check out some of the great benefits and find out how it could be a useful savings tool for you. 

How does an HSA work?

An HSA is a savings account for healthcare costs that you’re eligible to sign up for if you carry a high-deductible health plan. A High-Deductible Health Plan (HDHP) features lower premiums and sets an annual deductible at a minimum figure mandated by the federal government.

It helps you fund health care expenses by saving pre-tax money. Withdrawing HSA funds incurs no taxes when used for qualifying medical expenses like deductibles, coinsurance, copays, etc.

Furthermore, they serve as investment vehicles, enabling you to invest the funds similar to your 401(k) for enhanced growth. The balance persists from year to year, and it can be passed on to a beneficiary upon your death.

How do I qualify for an HSA?

Per Internal Revenue Service (IRS) Publication 969, to open an HSA, you must meet the following criteria:

• Be enrolled in a high-deductible health plan
• Not have any other healthcare coverage
• Not be enrolled in Medicare
• Not able to be claimed as a dependent on another person’s tax return

In 2023, the minimum yearly deductible for an HDHP was $1,500 for individuals and $3,000 for families. The maximum annual deductible was $7,500 for individuals and $15,000 for families.

Fortunately, you don’t have to rely on an employer to initiate an HSA. Any individual enrolled in an HSA-eligible healthcare plan and meeting the other criteria above may open and contribute to the account

What can an HSA be used for?

Technically, you can use the funds in your health savings account any way you wish, but in order to make tax-free withdrawals, you must use the funds to pay for eligible healthcare expenses. Refer to IRS Publication 502 for medical and dental expenses that are considered reimbursable by an HSA. Any medical expenses falling under these categories for you, your spouse, and qualifying dependents are eligible for tax-free HSA distributions.

The definition of qualified medical expenses is fairly broad. Deductibles, copays, and coinsurance are generally included in HSA-eligible costs. Here are some examples of the types of procedures and care that you can cover from your HSA:

• Annual physical exams
• Diagnostic services
• Chiropractor
• Vision exams and eyeglasses
• Fertility treatments
• Hearing aids
• Prescription drugs
• Psychiatric care
• Surgery
• Weight loss
• X-rays

Health insurance premiums

One major health-related expense that you typically cannot use your HSA to pay for is your health insurance premiums, though exceptions exist. You can use HSA funds for the following types of insurance premiums, per the IRS:

• Health care continuation coverage like COBRA
• Premiums paid while receiving unemployment
• Long-term care insurance
• Medicare and other health coverage if age 65 or older, except for supplemental Medicare policies like Medigap

To get reimbursements from an HSA effectively, you must keep meticulous records of all qualified medical expenses. Save receipts from healthcare providers and even drugstores where you purchase qualifying supplies until you take the HSA distributions. You must prove you haven't paid or been reimbursed from another source and haven't claimed them in itemized deductions in any tax year. Your HSA administrator may not require this documentation, but the IRS will in the event of an audit. 

If you use HSA distributions for things that don't count as qualified medical expenses as defined by the IRS, you’ll have to pay income tax plus a 20% tax penalty on the amount. However, once you reach age 65, you are no longer subject to tax on non-qualified HSA distributions (the same is true if you become disabled or die). 

How much should I contribute?

First of all, the federal government limits the amount any person can contribute to an HSA, but the limits go up most years. For 2023, the maximum contribution for self-only HDHP coverage was $3,850. For family HDHP coverage, the limit was $7,750. 

To reap the greatest benefit from your health savings account, you may want to contribute the maximum allowable amount. However, if that’s not possible, consider saving an amount equal to your healthcare deductible or out-of-pocket maximum.

Another strategy is to estimate your typical healthcare costs per year and aim to save that amount in your HSA. That’s because the money you put into health savings accounts is tax-free, and so are the withdrawals for qualified medical expenses, which could mean significant savings when you go to the doctor. 

How do I use my HSA to pay for healthcare expenses?

There are two ways you can use HSA funds to cover qualifying healthcare expenses. You can either pay medical expenses directly with your HSA or pay out-of-pocket costs yourself and delay reimbursement as long as possible. 

HSAs function much like checking accounts. If paying at the time of service or purchase, you can typically use either a debit card, check, or online bill portal connected to your HSA. Paying directly from your HSA still offers tax-free benefits for both your contributions and distributions. 

However, you’ll experience your HSA benefits more fully by choosing option two: funding medical expenses from your own non-HSA accounts and getting reimbursed at a later date. That enables your contributions to grow for years, earning you added retirement funds tax-free. If financially able, cover out-of-pocket costs for qualified medical expenses, delaying reimbursement from your HSA is ideal.

Tax benefits

Numerous financial experts highlight the tax benefits of transitioning, as they’re fairly impressive. When you make contributions, you benefit, as the federal level doesn't tax those dollars. Your funds can grow as an investment tax-free. Additionally, withdrawals for eligible medical expenses remain tax-free.

Not only do you get that triple tax benefit with an HSA, but tax penalties disappear when you reach age 65. Any distributions from your HSA made on or after age 65 are still subject to regular income tax, but without the 20% penalty. 

Numerous individuals opt to keep rolling over their funds, should they not require them for healthcare, turning it into an additional asset for retirement. Utilizing these funds proves advantageous for eligible medical expenses (which often rise after age 65), and there is no longer a tax penalty for non-qualified medical expenses.

FAQs

What is the downside of having an HSA?

One of the primary downsides of opening up an HSA is that you must enroll in a high-deductible health plan (HDHP). What that means in the short term is that you have a high out-of-pocket cost before any health benefits kick in for the year. 

Minimum deductibles for plans eligible for transition are high enough to present a financial hardship for many people, so you should carefully consider your healthcare needs before signing up for both an HDHP and this approach. It’s possible that the lower premiums will offset the higher deductible enough for you.

For some, the organizational requirements could be a downside as well. You must diligently keep records of medical expense receipts to ensure proper reimbursement from your HSA when the time comes. Plus, at tax time, you’ll need to file Form 8889 for contributions, withdrawals, and deductions. 

Is having an HSA a good idea?

On the whole, if you can afford a high-deductible health plan or are considering enrollment, opting for an HSA makes good financial sense. Transitioning to this approach provides a myriad of benefits from a taxation perspective, potentially reducing your out-of-pocket healthcare costs, and allowing the complete balance to roll over annually.

Nevertheless, as with any financial product, you must assess whether it’s the optimal route for you. Lack of funds or meticulous healthcare records means no benefit from this approach.

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