Benefits of Health Savings Accounts (HSAs)

What is a Health Savings Account (HSA)?

Health Savings Accounts (HSAs) are tax-advantaged savings vehicles available to those covered by a high-deductible health plan (HDHP).

• 401(k)s and IRAs offer tax benefits to save for retirement
• 529s offer tax benefits to save for education
• HSAs offer tax benefits to save for medical bills

What are the tax benefits of an HSA?

HSAs offer triple-tax benefits and are arguably among the most tax-advantaged savings vehicles. The main tax benefits are:

1. Tax-deductible contributions – contributions to HSAs are deductible for Federal income tax purposes and most states also allow a state income deduction (California and New Jersey are the two exceptions)
2. Tax-free growth – income and earnings within HSAs are tax-free, so long as withdrawals are made for qualified medical expenses
3. Tax-free withdrawals – withdrawals are also tax-free if used for qualified medical expenses

Example of HSA Tax Benefits

Imagine you have $1,000 in medical bills and your marginal tax bracket is 30%. To pay this bill, you can choose to (a) pay directly out of pocket with after-tax earnings, or (b) deposit $1,000 into your HSA to cover the medical costs.

If you choose to pay directly out of pocket, will have to earn $1,429 and pay $429 in taxes (30% of $1,429) in order to have $1,000 leftover for your medical bills.

But, if instead you deposit $1,000 into your HSA, that same $1,429 of earnings will leave you will an extra $300 in the bank.

How?

Take that same $1,429 of earnings and deposit $1,000 into your HSA. Your HSA contribution is tax-deductible, meaning only $429 of your $1,429 of earnings will be taxable. A 30% tax rate on $429 leaves you with $300 after-tax.

Your medical bill is paid using funds from your HSA and you still have $300 left in the bank, compared to nothing if you opted to pay out of pocket.

Additional HSA benefits

HSAs have several additional features that make them unique and powerful as part of a financial plan:

1. Not use-it-or-lose it – Unlike FSAs (Flexible Spending Accounts), HSA funds can be rolled over from year-to-year, are portable when changing jobs, and you can continue to use HSA funds even if you change to a non-high-deductible health plan in the future (although you won’t be able to contribute to an HSA in this case).
2. No income limits to contribute – HSA contributions and deductibility are not restricted based on income (unlike Traditional and Roth IRA contributions)
3. Retirement Savings – At age 65, withdrawals for non-medical expenses are no longer penalized, but are subject to taxation (just like traditional IRA withdrawals). Because of this feature, HSAs are an option for retirement savers.

What can HSA funds be used for?

HSAs must be used for qualified medical expenses in order to be tax- and penalty-free. However, in addition to doctor visits and procedures, you may be surprised by the long list of qualified medical expenses.

Eligible expenses include but are not limited to:

• Over-the-counter medications
• Birth control
• Therapy
• Acupuncture
• Physical Therapy
• Dental and Vision bills
• Contact lenses and solution
• Prescription eyeglasses
• Laser eye surgery
• And more

Am I eligible to contribute to an HSA?

You are eligible to contribute to an HSA if you are covered by a high-deductible health plan (HDHP). (You must not be covered by any other healthcare plans or Medicare.)

As of 2023, a high-deductible health plan is defined by the IRS as a plan with a minimum deductible of $1,500 for self-only or $3,000 for family coverage.

Premiums for high-deductible plans tend to be lower because you are paying more for your healthcare costs before your insurance company begins to provide benefits.

Basic Overview of Health Plan terminology

A few key definitions to understand when evaluating health insurance coverages:

• Premium – the cost for your insurance coverage; this is often a pre-tax deduction from your paycheck
• Deductible – the amount of medical costs you must pay out-of-pocket before your insurance provider begins to chip in
• Coinsurance – the percentage of medical costs after your deductible that you will continue to pay until you reach your out-of-pocket maximum; after meeting your plan’s deductible, your insurance company will begin to provide benefits but you will continue to “share” the costs through coinsurance.
  • For example, if your coinsurance is 20%, once you meet your plan’s deductible, you will continue to pay 20% of the cost of your medical bills and your insurance company will pick up the other 80%... until you meet your out-of-pocket-maximum.
• Out-of-Pocket-Maximum – the amount of medical costs you must pay before your insurance provider covers 100% of additional medical costs
• In-Network/Out-of-Network – health plans will often have different deductibles and out-of-pocket maximums for in-network and out-of-network providers; out-of-network amounts tend to be significantly higher

How much can I contribute to an HSA?

In 2023, your total HSA contribution is limited to $3,850 for self-only coverage and $7,750 for family coverage.

Importantly, these contribution limits include any employer contributions to your HSA. (This is different from common employer-sponsored retirement plans, like a 401(k), where your individual contribution limit does not include employer contributions.)

Many companies make contributions to employee HSAs as a benefit. If this applies to you, be sure to take your company contributions into consideration when deciding upon your HSA contribution amount.

What if I use HSA funds for non-medical expenses?

If you withdraw funds from an HSA for non-medical expenses prior to age 65, you will be subject to income taxes and a 20% penalty on the withdrawal amount. After age 65, withdrawals for non-medical expenses are no longer subject to the 20% penalty but are still taxable.

How much should you contribute to an HSA?

If you are certain of medical expenses in the near-term future, putting at least that amount into your HSA is a no-brainer. By contributing this amount to your HSA, instead of paying the expense directly out-of-pocket, you avoid taxation on these contributions and effectively need to earn less money to pay the same bills.

Beyond near-term expenses, putting more funds in your HSA is generally an excellent financial move given the account's benefits and flexibility. Even in retirement you could use your HSA funds for Medicare premiums or make penalty-free withdrawals for non-medical expenses.

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