Health Savings Accounts (HSAs) offer powerful tax benefits to people saving for future medical expenses. HSAs are also transferable if you change jobs and unused funds roll over to the end of the year. However, HSAs require participation in a high-deductible health plan (HDHP), which exposes savers to potentially high medical bills. They can only be used for eligible medical expenses, and violations of this rule can result in heavy penalties.

A Financial Advisor can help you make a financial plan for your health care needs and retirement goals.

HSA basics

HSAs are special trust accounts people can use to save for future medical expenses. They are highly tax advantaged. Employee or employer contributions can be deducted from current income, earnings from interest or investments grow tax-free, and later withdrawals are also tax-free if used for eligible medical expenses.

HSAs are only available to people covered by high-deductible health plans (HDHPs). The minimum amount of this deductible changes periodically. For 2022, eligible HDHPs must have minimum deductibles of $1,400 for individuals and $2,800 for families. Maximum disbursements, including the deductible, can reach $7,050 for individuals and $14,100 for families.

HSA Benefits

The tax advantages represent the main advantage. Contributions from employees, employers and family members do not count as currently taxable income for federal income tax purposes. And that includes FICA taxes as well as federal income taxes. This gives HSA savers immediate tax savings. And taxpayers can claim HSA assessments as deductions even if they don’t itemize their returns.

Tax-free growth means that interest and other earnings on funds in an HSA are also exempt from federal income tax. And tax-free withdrawal savers withdraw the money to pay for eligible medical expenses without, again, incurring federal income tax.

HSAs belong to the employee and can be retained across any number of job changes. The amounts are not lost if not used within a year and continue to grow through payroll deductions and investment earnings.

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In addition, HSAs are not subject to Minimum required distributions. This means that retirees do not have to withdraw funds from their HSAs unless they have eligible medical expenses they want to pay.

HDHPs charge lower premiums than more standard plans with lower deductibles. Pairing an HSA with an HDHP offers a potential money-saving combination of low insurance costs with tax benefits unmatched by any other savings vehicle.

HSA Disadvantages

The big downside to an HSA is that you have to enroll in a high-deductible health plan to qualify. It is difficult to accurately forecast medical expenses. So a family hit with surprise medical expenses might have to spend up to $14,100 in out-of-pocket expenses in a single year before insurance starts paying those expenses.

Tax Free HSA Withdrawals can only be made for eligible medical expenses, which include expenses incurred to treat or prevent illness. This covers expenses such as doctors’ bills, prescription drugs, and lab tests, as well as insurance copayments and coinsurance. However, it does not cover other health-related costs such as gym memberships and cosmetic surgery.

If withdrawals are used to pay ineligible expenses, the IRS will levy a 20% penalty on those amounts. In addition, withdrawals will be taxed as ordinary income. HSA users may have to keep detailed records showing that withdrawals were used for qualifying expenses, or risk these penalties.

Other considerations include fees charged by HSAs. While these can add up over time, they are usually far less than the potential tax savings that HSAs offer.

Another limitation is that people covered by Medicare, which includes most people over 65, cannot contribute to their HSAs, although they can keep them and use them to pay future medical expenses.

Finally, some states do not exempt HSA contributions from state income tax. So while an HSA may save on federal income taxes, it may not help with state taxes.

Conclusion

HSAs have nearly unparalleled tax advantages over other savings tools and can significantly help pay for future medical expenses. They are portable, have no expiry date, and can be used to pay for many health-related expenses. However, to get one, people have to join high-deductible health plans that expose them to potentially high health care bills. And if the withdrawals are used to pay for anything other than qualified healthcare costs, the penalties are severe.

Advice on paying for health care

• A Financial Advisor can help you implement a financial plan for your health care needs. Finding a qualified financial advisor doesn’t have to be difficult. SmartAsset’s free tool connects you with up to three financial advisors who serve your area, and you can interview your advisors at no cost to decide which one is best for you. If you’re ready to find an advisor who can help you achieve your financial goals, start now.

• HSAs are generally considered most attractive to younger, healthier people who don’t spend a lot on health care. Seniors and people with chronic conditions that incur significant healthcare costs may be better off with traditional insurance that doesn’t have an HSA but a lower deductible.

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