A Health Savings Account (HSA) is one of the most accessible tax shelters available. The only requirements for making contributions to an HSA are:
- You are not a dependent on someone else’s tax return
- You are not enrolled in Medicare
- Your only source of comprehensive healthcare coverage is a High Deductible Health Plan (HDHP)—most recently updated as one with an individual deductible of $1,600 or higher ($3,200 for families); and $8,050 or higher in maximum out-of-pocket expenses ($16,100 for families).
Unfortunately, it seems that the purpose of an HSA is commonly misunderstood and as a result, many taxpayers miss out on its most important benefits.
FSA v. HSA
Most people seem to understand the HSA as a different flavor of the Flexible Spending Account (FSA), which was established by law in 1978.
Here’s how an FSA works:
You allocate up to $3,200 a year (in 2024) from your paycheck to be set aside in an FSA. These are pretax funds that you can use to pay for a broad range of qualified medical expenses. If these funds remain in the account unused by year-end, they will most likely be forfeited. IRS regulations do allow up to $640 (in 2024) to carry over to the following year, but many employers have a strict use-it-or-lose-it policy. This policy forces account owners to take an educated guess at their healthcare expenses one year at a time.
The important point to remember is that the “S” in FSA stands for “spending” and the rules encourage you to do just that.
HSAs were signed into law in 2004, and many people treat them like FSAs—because that is the type of account they’ve had experience with.
The difference is that the “S” in HSA stands for “savings”—which means long-term benefits that FSAs don’t provide.
There is no annual limit to the amount of money you can spend from your HSA for qualified expenses. Unlike the FSA, unused funds can be carried forward indefinitely.
The idea is that when you are younger – with lower insurance costs and fewer health expenses – you can buy a low premium HDHP and funnel the savings into your HSA. As those savings accumulate, you can draw from the account to cover qualified medical expenses no matter when they arise.
Multiplying the benefits
While FSAs offer a modest annual tax break, HSAs offer these additional tax benefits:
- Tax-free growth on savings: An HSA’s offerings typically include the ability to allocate your savings into mutual funds or other investments. Some custodians have a better range of offerings than others, and most will require a minimum account balance before you can take advantage of the investment options. This ability to save and grow pretax money is a distinguishing feature of the HSA.
When you withdraw money for qualified medical expenses – anything from acupuncture to X-rays (here’s the full list) – it never gets taxed, no matter how much of it you need to use.
- Flexibility on the timing of distributions: There is no time limit on using an HSA to reimburse yourself for medical expenses. As long as you maintain documentation of the expenses, you can take a tax-free reimbursement from your HSA today for out-of-pocket medical expenses you incurred years ago.
An example: You incur a major medical expense, but your income allows you to cover the out-of-pocket costs after your health insurance pays its share.
You may choose to leave your HSA investments alone so they continue to grow tax free. But if you need the cash later – perhaps after you retire – you can still reimburse yourself for the old expense.
Keeping good records is critical to such a strategy. The best game plan is to claim out-of-pocket medical expenses on Schedule A of your tax return. Even when total medical expenses are not enough to earn a deduction, Schedule A documents them. It’s a small extra effort today that can put more money in your pocket later on.
- Behaves like an IRA at retirement age: Once you turn 65, you can withdraw money from your HSA for any purpose without penalty. That money is treated the same as if it came from a traditional IRA or 401(k): taxable as ordinary income, whether you use it for rent, world travel or anything else. That being said, withdrawals are still tax-free when used for qualified medical expenses, so that remains the optimal use of these funds.
The upshot is that if you have limited money to put into savings, the HSA eliminates the hard decision whether to allocate it to retirement vs. future medical expenses. The HSA lets you do both.
Funding your HSA
The maximum annual HSA contribution for 2024 is $4,150 for individuals ($8,300 for families). At age 55 and up, you’re allowed to make an annual “catch-up contribution” of an extra $1,000.
Also of importance, there’s no income-based phaseout to the benefit. The rules and limits are the same for high-income earners as for everyone else.
There are two routine ways to contribute:
- If done through corporate payroll, you can have pretax money from each paycheck deposited into the HSA.
- You can contribute directly from your own bank account and take a deduction for contributions on your tax return.
For those who haven’t yet reached the age of 59 ½, the rules for HSAs also allow a one-time rollover of funds from another source without being taxed or penalized. Two examples where this rollover would be useful: 1) You want to use money from your IRA to get started with an HSA; or 2) You have a medical issue and not enough money in your HSA to cover it.
Like an IRA, HSAs also provide flexibility for tax planning by allowing you to make contributions through April 15 for the prior tax year.
How much to save
According to Fidelity Investments, individuals who retired during 2023 at age 65 can expect an average of $157,500 in healthcare and medical expenses over their remaining years ($315,000 for couples). This estimate assumes enrollment in traditional Medicare (Parts A, B and D).
People often start to sweat when they see these numbers. The first lesson is the earlier you start saving, the better. The second lesson is it’s never too late to start. Regardless of when you start saving, be sure to optimize the various tax saving features of your HSA.
Mike Salopek, CPA, is a partner at Neitzel, Luke & Salopek Inc., Westlake, OH. He earned his B.S. and MBA degrees at John Carroll University.