How Does a Health Savings Account (HSA) Work?

With soaring healthcare costs, American families can face severe financial struggles or bankruptcy from a medical procedure or ongoing medical care. Insurance is designed to protect you from these soaring costs, but many plans have high deductibles or limited coverage. What can you do if the best medical choice isn’t covered by insurance or you suddenly face major healthcare expenses? Enter health savings accounts (HSAs). Read on to learn an HSA works and find out whether it can help protect your family. 

9 Features of a Health Savings Account (HSA)

How does an HSA work? HSAs provide a way for people to set aside funds for future healthcare costs while enjoying certain tax benefits. With a health savings account, the funds remain yours, and you can withdraw them for nonmedical expenses after age 65. Here’s a breakdown of the main features to better understand how an HSA works.

Eligibility Criteria

To be eligible for a health saving account, you must be enrolled in a high deductible health plan (HDHP) and have no additional health coverage. You can’t be claimed as a dependent on someone else’s tax return in the previous year. 

Exceptions to the “no other coverage” rule are insurance or other coverage for disability, dental, vision, telehealth or long-term care. You may also have coverage for a specific illness or disease, a fixed amount per day for hospitalization and insurance for liabilities related to worker’s compensation laws.

To qualify as an HDHP, insurance must meet the minimum annual deductible set by the IRS. For 2022, insurance qualified as an HDHP must have a minimum deductible of $1,400 for an individual or $2,800 for a family. The total out-of-pocket costs for an HDPD, including deductible, copayments and out-of-pocket expenses, can’t be more than $7,050 for an individual or $14,100 for a family.

Account Setup

You can open a health savings account through any qualified financial institution, such as a bank or a credit union. You can ask your local bank whether they offer an HSA. While procedures vary by bank, generally, you will need to complete the necessary paperwork that includes personal information, show a government-issued ID and designate a beneficiary of the account.

How does a health savings account work? When choosing where to open an HSA, consider whether the financial institution offers a debit card and whether there are fees associated with maintaining the account, such as monthly or transaction fees. Also check standard interest rates and the possibility of investing the HSA in stocks, bonds or other asset classes. Finally, check how you can make deposits into the account and withdrawal options. Find some of the best HSA providers here.

Contributions

Anyone can make contributions to an HSA. Not only can you and your employer contribute, but friends, relatives and anyone else may contribute to your HSA.

For individuals, the annual contribution limit for 2023 is $3,850. For families, the contribution limit is $7,750. Anyone age 55 or older can contribute an additional $1,000 per year.

While anyone can contribute, all contributions count toward the limit. That means if your employer contributes $2,000 and you have an individual HSA, you can only contribute a maximum of $1,850.

The main advantage of HSA contributions includes the ability to contribute pre-tax dollars. You can deduct HSA contributions from your total reported annual income. For many, that is a major advantage — if you use HSA contributions for medical expenses, you can withdraw them tax-free.

Tax Benefits

There are three major tax advantages to health savings accounts. First, all contributions up to the IRS limits are tax-deductible, reducing your total taxable income for the year. Second, many HSAs allow you to invest the funds for potentially greater growth. All interest and investment gains earned on an HSA grow tax-free. 

Third, if you deduct HSA funds for medical purposes, you don’t have to pay taxes on them. These three advantages, taken together, mean that if you use the funds for qualified medical expenses, you’ll contribute pre-tax dollars, they can grow tax-free, and they are tax-free on withdrawal.

Using Funds

You may use HSA funds for all qualified medical expenses. IRS guidelines specify which medical expenses are included, and some alternative or natural medicine professionals like a midwife or chiropractors are allowed.  Generally, HSA-qualified medical expenses include:

• Insurance deductibles
• Insurance copayments
• Medicines, both prescription and over-the-counter
• Procedures not covered by other health insurance, such as a midwife, orthodontics, eyeglasses or fertility treatments 

Other expenses, like baby care products, aromatherapy and personal care products like shampoo, aren’t considered qualified medical expenses. Review IRS guidelines or consult a tax adviser for clarification on qualified expenses with reference to your specific needs. 

Account Management

Managing an HSA is relatively simple. You can open an HSA at many banks or financial institutions. Check whether they offer a debit card or checks linked to the account to make qualified medical expenses. 

Most banks will give you online access or a mobile app to manage the account, monitor the balance and track expenses. You can usually deposit funds into the account through bank transfer or direct deposit. 

Once the funds are in the account, you can invest them or leave them to accrue interest like a savings account. 

Rollover and Investment

With health savings accounts, you can roll one HSA into another once a year without incurring tax penalties. You might choose to roll over to consolidate HSAs with a spouse or to move funds to a bank with lower fees. Of course, unused funds in the HSA automatically roll over in the account from year to year. 

Investment options available with some HSA providers offer the possibility for greater growth. While many choose bonds or other low-risk investment vehicles, some HSAs also allow other types of investment. 

Portability

Health savings accounts are portable, meaning that unused funds carry over from year to year, and you retain ownership of the account regardless of changes in employment. Even if you change jobs or health insurance plans, the account stays with you. The funds are always available for qualified medical expenses, regardless of employment or insurance status, adding a layer of savings.

Retirement Savings

Some people use HSAs as an additional retirement savings vehicle because of their tax advantages. Like a traditional IRA or a 401(k), you’ll deposit pre-tax dollars into an HSA, and they grow tax-free. If you don’t withdraw the funds for qualified medical expenses, from age 65 onward you may withdraw funds without penalty for other expenses and pay your applicable income tax rate. This potentially allows increased tax-free growth of funds

You also can continue to use HSA funds tax-free for qualified medical expenses after reaching age 65. If you no longer have medical expenses or change insurance coverage, you can withdraw the funds for nonmedical purposes, subject to income tax.

How an HSA Works for You

HSAs offer significant advantages to reducing the total tax burden in a year while building a financial safety net for medical expenses. The flexibility to use the funds for nonmedical expenses after age 65 means that an HSA can also be a vehicle to grow retirement savings. Because HSA, 401(k) and IRA limits are separate, you could potentially contribute to all three to save even more. Whether you maximize HSA savings or build a small cushion, an HSA is designed to work for you.

Frequently Asked Questions