What is health savings account and how does it work

A health savings account, or HSA, is an account you use to pay for qualified medical, pharmacy, dental and vision expenses and save on taxes. The key things to know about HSAs are:

Table of Contents Show

What is the downside of an HSA?
What is the benefit of a health savings account?
Can I use money from my health savings account?
What happens to money left in health savings account?

You must be covered by a high-deductible health plan to open an HSA
You own your HSA and the money in it
It’s not a “use it or lose it account”; funds roll over from year to year
Anyone can deposit money in your HSA, up to an annual limit set each year by the IRS

Compared to other health spending accounts, HSAs give you more ways to save on taxes and health care expenses, now and in the future.

How do health savings accounts work?

HSAs are tax-exempt savings accounts used in conjunction with a high-deductible health insurance plan to pay for qualifying medical expenses.

Individuals who participate in a qualifying high-deductible health insurance plan (HDHP) can establish a health savings account (HSA) to pay for qualifying medical expenses. Both employees and employers can make contributions to an HSA.

HSAs have many tax advantages. Contributions made by employers are exempt from federal income and payroll taxes, and account owners can deduct their contributions from income subject to federal income taxes. Further, any income earned on the funds in an HSA accrues tax-free, and withdrawals for qualifying medical expenses are not taxed. Withdrawals used for nonqualifying expenses are subject to income tax and an additional 20 percent penalty. But the penalty is waived for account holders who are disabled, who are ages 65 or older, or who have died. Unused balances can be carried over from year to year without limit.

Annual HSA contributions in 2020 are limited to $3,550 for an individual and $7,100 for a family. Account holders ages 55 or older can contribute an additional $1,000 to either type of account. The contribution limits are indexed annually for inflation.

In 2014, employers contributed $15.6 billion to HSAs, and individual tax filers contributed another $4.4 billion. The US Department of the Treasury estimates the tax preference for HSAs reduced income and payroll taxes by $7 billion in 2014.

Employers must offer an HSA-qualified insurance plan—usually an HDHP—for an employee to be eligible for an HSA. Individuals may also purchase an HSA-qualified insurance plan through the individual insurance market. A plan is HSA-qualified if it meets certain requirements; in 2020, these include a minimum deductible of $1,400 for individual coverage and $2,800 for family coverage.

HSAs are an expanded version of medical savings accounts (MSAs), established in 1996. Similar to HSAs, MSAs have many of the same tax advantages and also require account holders to have an HDHP. They are limited, however, to the self-employed or workers in small firms (50 or fewer employees). The Medicare Prescription Drug, Improvement, and Modernization Act authorized HSAs in 2003 to address the rising cost of medical care and the increasing number of uninsured individuals. No new contributions to MSAs could be made after 2007, except for individuals who previously made contributions to an MSA or who work for employers that had already established MSAs.

HSAs and their associated HDHPs place more of the health care financing burden on out-of-pocket costs and are intended to encourage more cost-conscious health care spending. In practice, HSAs are most attractive to higher-income individuals because the tax exemptions associated with contributions, account earnings, and withdrawals are of greater value for higher income-tax brackets. Additionally, high-wage workers are more likely to be constrained by contribution limits for retirement accounts and use HSAs as an additional means of tax-preferred saving.

In 2014, 11.7 percent of taxpayers with income between $100,000 and $200,000 contributed to an HSA, as did 16.4 percent of taxpayers with income over $200,000 (figure 1). In comparison, only 5.1 percent of taxpayers with income between $30,000 and $50, 000 made such contributions. The average contribution for taxpayers with income over $200,000 was $4,716, compared with an average contribution of $1,500 for taxpayers with income between $30,000 and $50,000 (figure 2).

HSAs are also attractive to those who expect low health care expenses. These individuals enjoy the premium cost savings associated with HDHPs, as well as the HSA tax benefits, without fear of eventually paying a high deductible.

What is the downside of an HSA?

What is the main downside of an HSA? The main downside of an HSA is that you will have a health insurance plan with a high deductible. A health insurance deductible is the amount of money you will need to pay out of pocket each year before your insurance plan benefits begin.

What is the benefit of a health savings account?

A type of savings account that lets you set aside money on a pre-tax basis to pay for qualified medical expenses. By using untaxed dollars in a Health Savings Account (HSA) to pay for deductibles, copayments, coinsurance, and some other expenses, you may be able to lower your overall health care costs.

Can I use money from my health savings account?

You can withdraw funds from your HSA anytime. But keep in mind that if you use HSA funds for any reason other than to pay for a qualified medical expense, those funds will be taxed as ordinary income, and the IRS will impose a 20% penalty.

What happens to money left in health savings account?

A health savings account (HSA) allows you to invest money to cover future healthcare costs. If you accumulate more money than you need, the unused funds in your account will go to your beneficiary when you die.