Health Savings Account Basics – What Are HSAs and Should You Enroll?

Health savings accounts (HSAs) were created in 2003 to give consumers facing high deductibles a tax-advantaged way to save for medical expenses.^[0]

Perhaps your employer is offering an HSA-qualifying high deductible health plan (HDHP) this year for the first time, or maybe you’re shopping individual health plans and are considering pairing an HSA with a qualifying high deductible health plan (HDHP) to help with out-of-pocket costs.

Whatever the reason, it’s important to understand how HSAs work so you can make them “work” for you. We’ll cover some HSA basics in this blog post, including:

• What an HSA is and how to open one
• 2020 annual contribution limits
• What you can use HSA funds for
• Who may want to open an HSA
• Other options to help with out-of-pocket healthcare costs

Please note that the materials available at this website are for informational purposes only and not for the purpose of providing legal or tax advice. You should contact your attorney or tax professional to obtain advice with respect to any particular issue or problem.

What are HSAs and How Do They Work?

An HSA is a type of savings account where you set aside money on a pre-tax basis to help pay for qualified medical expenses, including health insurance deductibles, copayments, and coinsurance. By using untaxed dollars from an HSA in this manner you may be able to lower your overall healthcare costs.^[1]

Here are some of the basic features and limitations of HSAs:

• You can only open and contribute to an HSA if you have an HSA-qualifying high deductible health plan.^[2] You also must be under age 65 in order to open or contribute to your HSA.^[3]
• After you open your HSA and have accrued a balance, you can withdraw those funds at any time tax-free to use for qualifying medical expenses (more in the next section).
• Or you can reserve more of your HSA funds now and invest them…more on that below.
• Unused HSA funds roll over from year to year^[4] and your HSA is “portable,” meaning that it goes with you, whether you change jobs or change health plans.^[5]
• Before age 65, if you use HSA dollars for a non-qualifying medical expense, you’ll pay ordinary income taxes on that withdrawal and a 20% penalty.^[6]
• After age 65, any withdrawals not used for qualifying medical expenses will still be taxed as ordinary income though you won’t be subject to the additional penalty.^[7]
• There are annual HSA contribution limits – employer-provided contributions count towards that limit.^[8]

2020 Maximum Annual Contribution Limits^[9]

	Individual	Family
Under Age 55	$3,550	$7,100
Age 55+ Catch Up Contribution	$1,000	—

The IRS has rules for how much you can contribute if you enroll in or lose an HSA-qualifying HDHP part-way through the year. Learn more about specific use cases and the “last month rule” at IRS.gov.

What Can You Use HSA Funds For?

You can use HSA funds for qualified “medical expenses” without incurring a penalty. Qualified medical expenses are those that “generally would qualify for the medical and dental expenses [tax] deduction.”^[10] As mentioned earlier, using your HSA funds for anything that does not qualify as a medical expense may result in a 20% penalty on top of the withdrawal being subject to income tax.^[11]

The IRS further defines “medical expenses” in Publication 502 in part, as: “…the costs of diagnosis, cure, mitigation, treatment, or prevention of disease, and for the purpose of affecting any part or function of the body. These expenses include payments for legal medical services rendered by physicians, surgeons, dentists, and other medical practitioners.”^[12]

The health insurance out-of-pocket costs that you’re responsible for when you obtain healthcare (deductible, copays and coinsurance) count as medical expenses. Your HSA dollars may also cover services and medical equipment that your health insurance policy does not cover at all, such as dental or vision care.

Some of the new or lesser-known qualifying medical expenses include:

• Over-the-counter medications like pain relievers, allergy, acne, cold and cough medicines – this recent change reversed a 2009 change as part of the Coronavirus Aid, Relief, and Economic Security Act (CARES, passed March 27, 2020)^[13]
• Menstrual and feminine hygiene products: tampons, pads and liners (also a result of the CARES Act)^[14]
• Health insurance premiums if you’re receiving unemployment benefits^[15]
• Premiums for Medicare parts B and D and Medicare Advantage Plans (not Medicare supplement plans)^[16]
• Acupuncture and Chiropractic^[17]
• Dental treatment to prevent and alleviate dental disease (not including teeth whitening)^[18]
• Fertility enhancement treatments like in vitro fertilization^[19]
• Vision care such as eye exams, contact lenses, eyeglasses and vision correction surgery^[20]
• Psychiatric care, medical care provided by a psychologist, and therapy^[21]
• Long term care services^[22]

And there are a lot more. If you have questions about whether specific medical products or services are covered, you’ll want to contact your HSA provider.

How To Access Your HSA Funds

HSA distributions typically occur one of two ways, either by:

Paying for qualified expenses directly – Many banks provide a debit card for use at the point of care or when paying your portion of a medical bill with your health savings account.^[23]

Paying a different way, such as a debit or credit card, then reimbursing yourself with your HSA funds later. And that can sometimes be much, much later, since there is no time limit for reimbursing yourself from your HSA.

In either case, you’ll want to keep receipts of qualified expenses that you used your HSA funds for. If the IRS becomes involved, you may need to prove that:

1. Your HSA withdrawals were only used for qualified medical expenses
2. They weren’t paid for or reimbursed from another source (like insurance)
3. You didn’t also take an itemized deduction for these medical expenses^[24]

So why would someone wait to reimburse themselves from their HSA? Why wouldn’t they just use their HSA dollars immediately when paying for healthcare?

Some people use HSAs not just as a health savings account, but as a “wealth-building tool.” We’ll look more at that unique feature of HSAs next.

HSAs as a “Wealth Building” Tool

HSAs can actually function beyond just being a “savings account” for health-related monies. In fact, they’re often referred to as a “triple tax-advantaged financial tool” because contributions to HSAs:

1. Can lower your federal income tax rate
2. Grow tax-deferred
3. Can be withdrawn tax-free for eligible medical expenses anytime^[25]

Here are a few other features and limitations to keep in mind if you’re considering leveraging an HSA this way:

Rolls over, portable: As previously mentioned, an HSA is not “use it or lose it,” (that’s a flexible spending account, or FSA) and they are portable. If you started an HSA with one employer, then changed jobs or lost your health insurance or enrolled in a new policy, you keep your HSA and can still use those funds anytime for medical-related expenses.^[26]

Contribute only while enrolled in a HDHP: Enrolling in an HSA-qualifying HDHP is what makes you eligible to contribute to an HSA. If you lose your qualifying health plan because you changed jobs or insurance plans, you can no longer continue to contribute to your HSA.^[27] Also, if you’re enrolled in a high deductible health plan that is not HSA-qualifying, you won’t be able to open an HSA.

Invest in mutual funds, stocks or ETFs: Contribute as much as you can now to your HSA (up to the annual contribution limit) and use fewer of those funds now for healthcare (particularly if you’re younger, healthier and have other ways to pay for care), and you can invest a portion of your HSA into mutual funds, stocks or exchange-traded funds (ETFs).^[28]

If you’re able to invest the maximum annual amount over a longer period of time, your HSA can grow into a fairly significant source of income later in your life. For example, if you contribute the individual maximum of $3,550 each year for 35 years, less $1,000 per year that you may withdraw for medical expenses, an annual average of 5% on the balance of your HSA results in an account worth around $250,000.^[29]

The HSA you contribute to today could be especially helpful after you retire since:

• You may need more healthcare later in life, including long term care services
• It’s likely healthcare costs will continue to go up
• You can pay some Medicare premiums with tax-free HSA funds without having to dip into other savings

While the savings and investment potential for HSAs may be attractive, it’s important that you do not skip necessary healthcare in an effort to save more of your HSA funds.

Remember, the primary purpose for your HSA is to help you afford healthcare, including healthcare you may need today.