Introduction to Health Savings Account (HSA)

A health savings account (HSA) is a tax-advantaged savings account that you can use for medical expenses. You can take advantage of an HSA when you choose a qualifying health insurance plan; typically a high deductible health plan (HDHP). Recently, our employer switched to an HDHP that offers lower monthly premiums in exchange for a higher deductible (the amount you pay out of pocket before insurance kicks in). Along with this change in our health care plan, our Flexible Spending Account (FSA) was replaced with an HSA.

HSA vs FSA

Overall, an HSA can be used just like an FSA. Like an FSA, your payroll contributions are made with pre-tax dollars, which may help lower your tax bill; and you can use money in your account for eligible medical expenses. Another similarity is that the convenience, most HSAs will issue a debit card to you. If you use the debit card to immediately pay for your eligible medical expenses, you won’t have to go through a reimbursement process.

On the negative side, you have to have money in your account first before you can use it; whereas you can use the full amount in your FSA before you fully fund the account for the year.

On the positive side, there are many benefits to an HSA when compared to an FSA.

You can contribute a lot more money to an HSA.
Unlike an FSA where you loose unused funds, the money in your HSA does not expire at the end of the year. You can keep them as long as you want to.
The money in your account is yours to keep even if you change jobs.
If you become disabled or reach age 65, withdrawals can be made for non-medical reasons without penalty, but amounts must be reported as taxable income. Effectively, your HSA works like a Traditional IRA at this time.
HSA can be used for a wider range of expenses, limited only by legislation and IRS guidelines.

The combination of a lower monthly insurance premium payment and an HSA account — designed to help people pay for health care expenses with significant tax savings — is an ideal way to save and pay for health care needs now and in the future.

HSA Contribution Limits

The federal government sets limits on how much you can contribute to an HSA in a tax year. The table below displays the current HSA contribution limits. Current contribution information can be found on HealthCare.gov.

Tax Year	Individual Coverage Limits	Family Coverage Limits
2019	$3,500	$7,000
2020	$3,550	$7,100

After the age of 55, members can contribute an additional $1,000 towards their HSA (either individual and family coverage).

HSA Eligible Expenses

You can use your HSA money for eligible healthcare expenses beyond what your plan covers. Here are some of these expenses:

Medical expenses that you pay out of pocket before you’ve met your deductible.
Copayments and coinsurance.
Prescription drugs.
Dental and vision care expenses not covered as part of your health plan.
Long-term care premiums.

Although the definition of eligible expenses is very broad, you cannot use your HSA money to pay your health insurance premiums or expenses that are not related to medical treatment.

HSAs and Taxes

As mentioned above your contributions are made with pre-tax dollars, which may help lower your tax bill. Here are some key points with regard to withdrawals:

When being reimbursed from your HSA for eligible medical expenses, you do not pay tax on the withdrawal.
You must pay income taxes plus an additional tax of 20% on any HSA amount used for non-eligible medical expenses.
If you become disabled or reach age 65, withdrawals can be made for non-medical reasons without penalty, but amounts must be reported as taxable income. Effectively, your HSA works like a Traditional IRA at this time.

Health savings accounts offer tax deductions on federal income tax for any deposits made to the account. Many states also offer the same deductions on state income taxes. However, the individual states can choose to comply with the federal guidelines concerning the tax treatment of HSAs, or establish their own rules. For example:

California and New Jersey do not allow an HSA tax credit for state income taxes.
New Hampshire and Tennessee tax HSA earnings (interest and dividends).

Be sure to check with your tax advisor to determine your state’s current status and guidance in preparing your tax returns.

IRS Reporting Requirements

The IRS states that HSA contributions and withdrawals are reportable transactions. Tax deductions are generally available either to the eligible individual and/or the employer. Withdrawals from HSAs for eligible medical expenses will avoid income tax consequences to the HSA holder. That’s why the IRS requires these withdrawals to be reported. To make reporting withdrawals easier, the IRS offers forms to be used by the parties involved.
Regardless of whether HSA contributions are made by you or your employer, the contributions must be reported on your tax return. Contributions to and withdrawals from HSAs are reported by the account holder on Form 8889.
The employer is required to report employer HSA contributions to the IRS on the tax return that is filed by the employer. Employer HSA contributions, including employee pretax contributions through a cafeteria plan, are also reported on the W-2 (Box 12, code W) for each employee.

Tax Treatment of Your HSA

Interest and Dividends – Earnings on amounts contributed to an HSA are generally not taxable. However, some states do tax HSA earnings, for example, New Hampshire and Tennessee.
Eligible Withdrawals – There is no restriction on when and how often you may request withdrawals from the HSA. When you or your dependents incur an eligible medical expense, a withdrawal from the HSA may be made to reimburse you for the expense.
Non-eligible Withdrawals – Withdrawals that are not for eligible medical expenses are always included in your gross income. In addition, such withdrawals are generally subject to an additional 20% penalty, unless the withdrawal is made after death, disability or reaching age 65.

Taking Full Advantage of Your HSA

The key thing to take away from this is that an HSA is much more than an FSA. Sure you can use it as a substitute for an FSA, but it is much more powerful to use it as an extension of your retirement plans.

Like a Traditional IRA and 401(k), you can contribute an additional $3,550 for an individual or $7,100 for a family in pre-tax dollars in 2020. The contributions can potentially result in tax savings at tax time. Similarly, the money is generally protected from creditors. Your goal is to keep adding and investing the money and avoid withdrawing unless you have an absolute need to pay for a medical emergency.

By saving and investing your HSA early on, it is possible that you can cover your future medical expenses from interest and dividends that your HSA investments generate. How cool would that be!?

HSA vs Traditional IRA

There are a few key differences to keep in mind when you employ this strategy:

Early Withdrawal – You have to pay income taxes plus a 20% tax (vs. income taxes plus a 10% penalty for a Traditional IRA).
Withdrawal Age – Eligible withdrawal age is 65 (vs. 59½ for a Traditional IRA). However, you can withdraw for eligible medical expenses at any time.
Required Minimum Distribution – There is no RMD for an HSA (vs. an RMD requirement starting at age 70½ for a Traditional IRA)

On the negative side, since HSA investment choices and fees are most likely limited by the custodian that your employer chooses, you most likely will not have access to the best investments and the lowest fees. This is something to keep in mind. However, this is not much different from the limitation of your 401(k) plan and it should not be a deterrent for you to invest with an HSA.