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Understanding the Pros and Cons of a Health Savings Account (HSA)

A health savings account (HSA) can be a great way to save money on your healthcare expenses, but to use them effectively, it’s important to understand how they work and the potential drawbacks.

If you’ve been working, paying taxes, and paying for medical expenses for a while, you’ve probably heard of an HSA. Short for “health savings account,” an HSA is a type of personal savings account that can be used only for medical expenses. HSAs can offer significant tax advantages, as you make contributions to the account with pretax dollars. This means that you can pay for eligible medical expenses with untaxed money, and can add up to serious savings when tax time comes. It’s important to note that you are typically only eligible for an HSA, if you are enrolled in a high-deductible health plan (HDHP). 

ALthough there are many compelling reasons to consider using an HSA, there is an important downside to think through. If you don’t use all of the money in your HSA properly, it can be expensive to withdraw. If you withdraw funds from your HSA for non-qualified expenses before you turn 65, you’ll owe income taxes plus a 20% penalty.

Read on for a detailed explanation of HSAs and their pros and cons. No time to read the full article? Here’s the TLDR cliff notes (and you can always reach out for a free consultation with one of our experts):

KEY POINTS ABOUT HSAs

  • An HSA is a way to help cover your out-of-pocket medical expenses if you have a high-deductible insurance plan.
  • Contributions to your HSAs are made with pre-tax dollars, and all investment earnings in the account are also tax-free.  
  • If you use funds from your HSA to pay non-qualified expenses before you turn 65, you’ll owe income taxes plus a 20% penalty. After 65, you’ll owe taxes but not the penalty.
  • Unlike flexible spending accounts (FSAs), and HSA is not a “use it or lose it” situation. If you do not spend all of the money in your HSA, it will roll over to the following year, so it’s available for future health expenses.

What is a Health Savings Account (HSA)?

An HSA is savings account that is exempt from federal taxes and is available only to people with high-deductible health insurance plans. You can only use the money in an HSA to pay for qualified medical expenses. If you use the funds in your HSA for non-qualified expenses, you must pay income tax on the withdrawal plus a 20% tax penalty. (Note, the penalty is waived if you’re 65 or older, but you will still owe taxes.) 

Who Should Consider an HSA? 

You must have a high-deductible health insurance plan (HDHP) to be eligible for an HSA. Pairing the two is quite common, so they are often offered together. 

In addition to the HDHP requirement, there are a few other eligibility standards set forth by the Internal Revenue Service (IRS). In order to qualify for an HSA, you cannot have other health coverage, be enrolled in Medicare, or be claimed as a dependent on someone else’s tax return. 

Do the Funds in an HSA Account Expire? 

No—HSA funds do not expire or have a deadline. They will be in your account forever and simply roll over from year to year. 

Is an HDHP a Good Idea? 

An HSA is open only to people with HDHPs. Although the tax advantages of an HSA might make you think that signing up for a high deductible health plan is a no brainer, there are important drawbacks you should consider. The biggest con to an HDHP is the fact that expenses can really mount up if you have serious medical issues. If you are young and healthy with no chronic conditions that require regular medical treatment, an HDHP may be a good choice for you. 

What Type of Expenses are Eligible for HSA Funds? 

The IRS dictates that you can use funds from your HSA for qualified medical expenses. The list is long and detailed, including things like prescription drugs, co-pays, deductibles, dental services, vision care, psychiatric treatment, and more. You can find a complete list of updated qualified expenses in IRS Publication 502: Medical and Dental Expenses

Are There Any Limits to Annual HSA Contributions?

For 2022, the limit is $3,650 for individuals and $7,300 for family coverage for families. If you are 55 or older by the end of the tax year, you can also contribute an additional $1,000.

For 2023, the contribution limit increases to $3,850 for individuals and $7,750 for family coverage.

What are the Advantages of HSAs? 

The biggest advantage of an HSA is the fact that contributions are made with pre-tax dollars, allowing you to save on your tax bill by paying for qualified medical expenses with earnings that have not been taxed. In addition to that tax advantage, there are other advantages to consider:

Many Medical Expenses Qualify 

There is a very large list of expenses you can pay for with your HSA funds. See IRS Publication 502, Medical and Dental Expenses for complete details. The CARES Act of 2020 added over-the-counter medications and menstrual products to the already large list. 

Others Can Contribute to Your HSA 

Of course you know that you can contribute to your own HSA, but did you know that you can also get contributions from your employer, a relative, a friend, or anyone else who wants to contribute?

Tax-Deductible After-Tax Contributions 

If you make contributions with after-tax dollars, you can deduct the money from your gross income on your tax return, reducing your tax bill for the year. For example, if you’re an individual under the age of 55, your maximum allowed contribution is $3,650 in 2022 and to $3,850 in 2023.98

So, if you deposit only $2,600 into your HSA through payroll deductions by the end of 2022, you may choose to deposit an additional $1,050 to further lower your tax liability. You generally have until the IRS tax filing deadline to contribute.13

HSAs Have Tax-Free Earnings 

Any interest or other earnings on the money in the account is tax free. You can invest the funds in stocks, bonds, or other assets and use the account as a tax-free savings account for medical expenses in the future. 

HSAs Have No Expiration 

Once you contribute money to your HSA, those funds are there forever unless you withdraw them. If you have leftover money at the end of one calendar year, it rolls over to the next year.

This makes HSAs very different from FSAs, which have very limited options to carry over funds from year to year. 

HSAs Are Portable 

Any money in your HSA remains yours—available for future qualified medical expenses—no matter where or if you work and regardless of what health insurance plan you have. 

Most HSAs Are Convenient 

Typically, your HSA will give you a debit card that you can use to pay for medications, co-pays, and other eligible expenses. 

What Are the Disadvantages of HSAs? 

If you qualify for an HSA, you may be tempted to set one up right away. Although it may be the right option for you, you should consider the potential disadvantages: 

High-Deductible Requirement 

An HDHP can be stressful if you have an expensive medical issue or need an unexpected procedure or surgery. If you know you are likely to need extensive and costly medical care in an upcoming year, it might be worthwhile to switch to a plan with more expensive monthly premiums but a lower deductible.

Recordkeeping Requirements 

If you are using a HSA, you must keep receipts to prove that your withdrawals were used for qualified health expenses. 

Taxes and Penalties 

As stated earlier, the biggest drawback to consider about an HSA is the potential to incur a penalty if you need to withdraw funds for non-qualified expenses before you turn 65. In that case, you would owe taxes plus a 20% penalty to the IRS. After age 65, you only owe the taxes.

Fees 

Some HSAs charge a monthly maintenance fee or even a per-transaction fee. Those fees vary by institution and are typically relatively small, but they do normally outweigh any interest you might earn on the balance in your account. 

The Bottom Line on HSAs 

If you are certain that choosing a high-deductible health plan (HDHP) is right for you, then an HSA can be an attractive add-on to help pay for the expenses that you must cover with your high deductible. Want to talk with an expert about the details of your specific situation? Reach out for a consultation—our CPAs are ready to help!

Other Tax Resources from PRIME:

Fourth Quarter Tax Tips

Tax Implications of Student Loan Debt Relief