What Is an HSA?

Healthcare can be expensive, and even good health insurance can leave you paying deductibles, copays, prescriptions, and other out-of-pocket costs.

A Health Savings Account, or HSA, is a special account that allows eligible people to set aside money specifically for healthcare expenses. The money receives tax advantages, stays in the account from year to year, and can potentially be invested for future use.

An HSA can help you pay today's medical expenses while also giving you another way to prepare for healthcare costs down the road. The first step is understanding how it works and whether you're eligible to have one.

What Is an HSA?

A Health Savings Account, or HSA, is a special savings account you can use to pay for qualified healthcare expenses. What makes it different from a regular savings account is the tax treatment that comes with it.

There's an important connection between an HSA and your health insurance, though. You generally have to be enrolled in an HSA-eligible high-deductible health plan, or HDHP, to contribute to an HSA.

That means understanding an HSA also means understanding the health plan that comes with it.

How Does an HSA Work?

An HSA is an account where you can set aside money for healthcare expenses. Your employer may contribute money to the account, or you can contribute your own money if you're eligible.

You can generally use HSA funds for qualified medical expenses, including things such as doctor visits, prescriptions, dental care, vision care, and certain medical equipment and over-the-counter healthcare expenses.

Unlike money in a typical flexible spending account, HSA funds generally roll over from year to year. You don't have to use the balance by the end of the year.

The account also belongs to you. If you change jobs, the HSA stays with you.

One thing that's important to understand is that the HSA doesn't pay for your health insurance. Your insurance plan still determines what you owe when you receive medical care. The HSA simply gives you a tax-advantaged source of money you can use for qualified healthcare expenses.

Why Does an HSA Require a High-Deductible Plan?

This is where an HSA can either make sense or leave you wondering why you would bother.

An HSA-eligible health plan generally has a higher deductible than some other types of health insurance. A deductible is the amount you may have to pay toward covered healthcare expenses before your insurance begins paying its share, although certain preventive services may be covered before you meet the deductible.

The tradeoff is that a high-deductible plan may have a lower monthly premium.

For example,

One plan costs $500 a month with a $1,500 deductible

Another costs $300 a month with a $5,000 deductible

The second plan saves you $200 a month in premiums, but you could be responsible for significantly more of your healthcare costs before the insurance begins sharing those costs.

For someone who rarely needs medical care and can comfortably handle a large deductible, that tradeoff may work well. They can put some of the money they're saving on premiums into an HSA and build up funds for future healthcare expenses.

Someone who regularly sees doctors, takes expensive medications, or has ongoing healthcare needs may have a very different experience. The lower monthly premium may not make up for the higher costs when healthcare is actually needed.

That's why an HSA-eligible plan isn't automatically a better deal. The health insurance plan has to make sense for your healthcare needs and your budget first.

What Is the Tax Benefit?

The tax treatment is what makes an HSA different from a regular savings account.

When you're eligible to contribute, HSA contributions can receive favorable federal tax treatment. Depending on how you contribute, the money may go into the account before federal income taxes are applied, or you may be able to deduct your contributions.

Money in the account can also grow without federal income tax, including investment earnings if your HSA offers investment options.

Then, when you use the money for qualified medical expenses, you generally don't pay federal income tax on those withdrawals.

That's where the phrase "triple tax advantage" comes from: potential tax benefits when money goes in, tax-free growth, and tax-free withdrawals for qualified healthcare expenses.

But there is a tradeoff. A regular savings account gives you much more freedom to use your money for whatever you choose. An HSA's strongest tax benefits are tied to healthcare expenses.

So the real question isn't whether an HSA has tax advantages. It does. The question is whether those advantages are valuable enough for you to justify the health plan and the restrictions on how the money can be used.

Can You Save and Invest HSA Money?

You don't necessarily have to spend your HSA balance as soon as you have a medical expense.

For example, suppose you have $2,000 in your HSA and receive a $500 qualified medical bill. If you can comfortably pay that bill from your regular checking account, you could leave the HSA money alone instead.

Depending on the circumstances, you may be able to reimburse yourself from the HSA later for that qualified expense, provided you follow the rules and keep the appropriate records.

Some HSA providers also allow you to invest part of your balance. That gives you the opportunity to build the account over time rather than treating it simply as a checking account for medical bills.

This can make an HSA particularly interesting for someone who has relatively low healthcare costs and can afford to leave the money untouched.

There is also another benefit later in life. After age 65, you can generally withdraw HSA money for non-medical expenses without the additional 20% federal penalty that applies to non-qualified withdrawals before age 65. Those withdrawals are generally subject to ordinary income tax.

Qualified medical withdrawals can continue to be tax-free.

Is an HSA Right for You?

An HSA can be a valuable financial tool, but it isn't automatically the best choice for everyone.

It may make sense if you have an HSA-eligible plan, don't use much healthcare, can comfortably handle the deductible if something unexpected happens, and want to build tax-advantaged savings for future medical expenses.

It may make less sense if you have frequent medical appointments, significant prescription costs, ongoing treatment, or limited savings to cover a large deductible.

When comparing plans, look beyond the HSA itself. Consider the monthly premium, deductible, copays and coinsurance, out-of-pocket maximum, employer HSA contributions, your expected healthcare expenses, and how much you can realistically afford to save.

An HSA can provide real tax advantages. But those advantages don't automatically make a high-deductible health plan worthwhile if you're spending more out of pocket.

Final Thoughts

An HSA is a tax-advantaged account designed to help you save and pay for qualified healthcare expenses. The money can roll over from year to year, stay with you if you change jobs, and potentially grow through investments.

For the right person, it can be an excellent way to prepare for future healthcare costs while receiving valuable tax benefits.

For someone who needs a lot of healthcare or would struggle with a high deductible, a lower-deductible health plan may be the better choice, even without an HSA.

The account itself is only one part of the decision. The health plan, your healthcare needs, and your financial situation all have to work together.

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Up Next: An HSA isn't the only type of account that can help you set aside money for healthcare expenses. A Flexible Spending Account, or FSA, offers some similar tax advantages, but the rules are different — and those differences matter.

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How Does an HSA Work?

An HSA is an account you can contribute to if you meet certain eligibility requirements. You can put money into the account yourself, and your employer may also contribute.

You can then use the money for qualified medical expenses, including many common healthcare costs such as doctor visits, prescriptions, dental care, and vision care.

One of the biggest advantages of an HSA is that the money stays in the account if you don't use it. Unused funds generally roll over from year to year.

For example, if you contribute $2,000 during the year but only use $800 for qualified medical expenses, the remaining $1,200 stays in your HSA for future use.

The account belongs to you, so it generally stays with you if you change jobs.

Who Can Have an HSA?

You can't simply open an HSA and contribute money because you want one. You must meet specific requirements.

Generally, you must be covered by an HSA-eligible high-deductible health plan (HDHP). There are also other IRS requirements that can affect eligibility.

You generally can't contribute to an HSA if you have certain other health coverage or are enrolled in Medicare.

Having a high deductible by itself also doesn't automatically make a health plan HSA-eligible. If you're considering an HSA, check your health plan documents or ask your insurance company or employer whether your specific plan is HSA-eligible.

Why Are HSAs Tax-Advantaged?

HSAs have a unique tax advantage because you can potentially receive tax benefits when money goes into the account, while it's in the account, and when you use it for qualified medical expenses.

Contributions can generally be tax-deductible or made through an employer's payroll system on a pre-tax basis. Money in the account can grow without federal income tax, and withdrawals used for qualified medical expenses are generally tax-free.

This is often called the triple tax advantage.

For example, you contribute money to your HSA, leave some of it in the account, and eventually use it to pay a qualified medical expense. You may receive a tax benefit from the contribution, avoid taxes on investment growth, and avoid taxes on the withdrawal when it's used for an eligible expense.

State tax rules can differ, so federal tax treatment doesn't necessarily tell the whole story.

What Can You Use HSA Money For?

HSA money can generally be used for qualified medical expenses. These can include many everyday healthcare costs, such as:

• Doctor and hospital expenses

• Prescription medications

• Dental care

• Vision care

• Certain medical equipment

• Certain qualified over-the-counter medical expenses

The IRS determines what qualifies, so don't assume every health-related purchase is eligible.

Keep your receipts and other records. Your HSA provider may not ask for them when you use your account, but you are responsible for being able to document your expenses if you're ever asked to substantiate a withdrawal.

You can also pay a qualified medical expense with money from another account and leave your HSA funds untouched. You may later reimburse yourself from the HSA, provided the expense was eligible and you have the records to support it.

Can an HSA Be Used for Long-Term Savings?

An HSA doesn't have to function like a checking account that you empty every year.

Depending on your HSA provider and account balance, you may be able to invest some of the money. That gives your HSA the potential to grow over time rather than simply holding cash.

This can make an HSA particularly useful for long-term financial planning. Healthcare expenses can become a significant part of retirement, and money left in an HSA can continue to be used for qualified medical expenses years later.

There's another important rule after age 65. You can generally withdraw HSA money for non-medical expenses without the additional 20% federal tax penalty. Those withdrawals are generally subject to ordinary income tax, however.

Withdrawals for qualified medical expenses can continue to be tax-free.

That gives an HSA a unique place in long-term financial planning, especially for someone who can afford to leave some of the money invested.

What Should You Watch Out For?

An HSA can be valuable, but there are rules you need to understand.

First, make sure you're eligible to contribute before putting money into an HSA. Annual contribution limits apply and can change from year to year.

Second, understand the difference between qualified and non-qualified withdrawals. If you take money out for a non-qualified expense before age 65, the withdrawal may be subject to ordinary income tax plus an additional 20% federal tax.

Third, keep good records. You're responsible for being able to show that HSA withdrawals were used for qualified expenses if necessary.

It's also worth looking at the HSA provider itself. Providers can have different account fees, investment options, minimum balances, and other requirements.

Final Thoughts

An HSA is more than an account for paying today's medical bills. For someone who qualifies, it can provide a tax-advantaged way to handle healthcare expenses while allowing unused money to remain available for the future.

Before opening or contributing to an HSA, make sure your health plan is eligible, understand the contribution rules, and learn which expenses qualify.

The more you understand about how the account works, the more useful it can become.

Up Next: An HSA isn't available to everyone. Next, we'll look at Who Can Have an HSA? and the health insurance requirements you need to meet.