A health savings account is a special purpose financial account that allows a consumer to save and pay for medical expenses on a tax-favored basis. Funds deposited into an HSA are not taxed; the funds in the account grow tax deferred; and the money accumulated in the account can be withdrawn tax free to pay for qualifying medical expenses. In effect, an HSA owner uses the account in a manner similar to a checking account to cover his or her (or his or her family’s) medical expenses. There are no income restrictions or income requirements as to who may open and contribute to an HSA.
The HSA—the account and its funds—belongs to the individual. Contributions to an HSA can be made by the individual owner, by an employer, or by anyone on behalf of the individual owner. Any unused account balances and interest earnings carry forward from year to year; the money is never forfeited.
HSAs Require HDHPs
Health savings accounts do not stand on their own. The federal legislation that authorized HSAs stipulates that they must be established and used in conjunction with a high-deductible health plan that meets certain requirements. An HDHP that meets these requirements is referred to as “qualified” or as an “HSA-compatible” plan.Consequently, understanding HSAs requires understanding qualified HDHPs.
In order to establish and maintain an HSA, a person must also be enrolled in a qualified HDHP. A qualified HDHP must conform to the following guidelines:
A qualified HDHP must specify both a minimum annual deductible and a maximum annual out-of-pocket (OOP) expense limit, as set every year by the IRS. The minimum annual deductible is just that—the minimum amount that the insured must pay before the plan pays any benefit. The maximum annual OOP expense limit is the cap on the sum of the annual deductible and all out-of-pocket expenses the insured must pay for covered expenses under the plan. Out-of-pocket expenses include coinsurance and copayments; they do not include the plan’s premium payments. The OOP limits vary for individual coverage and family coverage. Once the insured reaches the out-of-pocket limit, all covered expenses are paid 100 percent by the HDHP for the remainder of the plan year.
For 2020, the minimum annual deductible and the maximum annual out-of-pocket expense limits for qualified HDHPs are:
2020 Health Savings Account (HSA) High-Deductible Health Plan Limits
Maximum Annual Out-of-Pocket Amount
A plan with a lower deductible or higher out-of-pocket expense limits would not qualify as an HSA-compatible HDHP. The insurer can design the plan so that the minimum deductible and the maximum OOP amounts apply to services received only from in-network services; costs incurred through services provided by out-of-network providers may not count toward either limit.
A qualified HDHP can cover preventive care without requiring a deductible or copayment. Indeed, if the HDHP is to meet the minimum coverage requirement for the Affordable Care Act, it must cover certain preventive services with no copayment, even during the deductible stage. Examples of preventive care include:
o annual physicals
o routine well-child care
o screening services
All services other than preventive care are subject to the deductible.
If an HDHP meets these criteria, it is qualified as HSA-compatible and will be labeled as such by the insurer.
Eligibility for an HSA
In addition to having a qualified high-deductible health plan in place, an HSA applicant must meet certain other requirements:
The individual has no other health plan coverage (with the exception of certain specified types of coverage).
The individual cannot be enrolled in Medicare.
The individual cannot be claimed as a dependent on another taxpayer’s tax return for the year.
These requirements are ongoing. In other words, they must be met initially to establish and open an HSA; they must also be met in future years in order for the owner to continue to contribute to the HSA. As long as the owner meets these requirements, he or she is “HSA-eligible.”
Beginning with the first month an HSA participant becomes enrolled in Medicare (including retroactive enrollments), no further HSA contributions are allowed. Although contributions must stop at this point, the accumulated dollars can be taken as tax-free distributions and can be used to pay for qualified medical expenses. If the money is used for nonmedical expenses, ordinary income tax will be due on the amount withdrawn, but no penalty applies.
Other Permitted Coverage
Although a person will not be eligible for an HSA if he or she is covered under another type of health plan, there are some exceptions. Specifically, a person may have an HSA and also have insurance that provides coverage or benefits for:
specified disease (e.g., cancer) or critical illness
liabilities incurred under workers compensation laws, tort liabilities, or liabilities related to ownership of property
hospitalization (coverage for which is specified as a fixed amount per day or per other period)
long-term care services
In addition, individuals may have a prescription drug plan, either as part of an HDHP or a separate rider, and still qualify as HSA-eligible as long as the plan does not provide benefits until the minimum annual deductible has been met. If benefits can be received before the deductible is met, the person is not HSA-eligible.
If the HDHP is a group plan, the employer may make contributions on behalf of an employee; in these cases, the employee, the employer, or both may contribute to the employee’s HSA in the same year. Family members or any other person may also make contributions on behalf of an eligible individual. Contributions to an HSA must be made in cash.
Employers that offer HSAs to their employees are not required to make contributions to the HSAs. However, if they do, they must do so in such a way that the contributions for each employee are comparable or nondiscriminatory. Once an employer contributes funds to an employee’s HSA, those funds belong to the employee and cannot be reclaimed by the employer.
For any given year, account holders can contribute in a lump sum or in any amounts or frequency they wish, up to the annual maximum, on whatever schedule suits them. However, the account custodian can impose minimum deposit and balance requirements. Contributions can be made at any time for any year, up to April 15 of the following year.
Limit on Contributions
The maximum contribution that may be made to an HSA varies based on the account holder’s age and whether the account holder has self-only coverage or family coverage. For 2020, the following contribution limits apply:
20 Maximum HSA Contribution
Individual HDHP coverage
Family HDHP coverage
For those age 55 and older, the annual contribution limit is increased by $1,000. This is known as a “catch-up provision.” This means that an age 55 or older HSA account holder who has self-only coverage may make a total maximum contribution to an HSA of $4,550 ($3,550 + $1,000 = $4,550) in 2020. Similarly, an age 55 or older HSA account holder who is covered under family coverage may make a total maximum contribution of $8,100 in 2020 ($7,100 + $1,000).
Spouses who are both HSA-eligible can set up separate HSAs in their own names, and each can contribute up to the maximum amount allowed every year to his or her own account. If each is older than 55, each can contribute up to an additional $1,000 per year.
Tax Treatment of Contributions
HSA contributions made by an individual are either tax-deductible or pre-tax. Pre-tax contributions are those associated with a group HDHP plan and are taken automatically from the participant’s paycheck, under a salary reduction agreement.24 (The participant agrees to reduce his or her salary by a specified amount and make contributions to the HSA of that amount.) In these cases, the individual’s HSA contributions are not included in his or her income and are not subject to FICA (Social Security and Medicare) payroll taxes. (In addition, the employer avoids FICA taxes under this type of arrangement.)
If the employer does not offer pre-tax deductions, or if the participant wants to contribute more to the HSA than the employer-authorized pre-tax amount, the participant can make an “above the line” contribution to the HSA and deduct that amount from his or her income for tax purposes when filing a tax return for the year. The deduction can be taken regardless of whether the individual itemizes deductions.
As just noted, employers may contribute to their employees’ HSAs, though there is no requirement that they do so. The amount an employer can contribute on behalf of each employee is not set or mandated, but contributions for all employees must be comparable—that is, they must be made on a fair basis across all employee groups. For example, if an employer makes an HSA contribution for a full-time participating employee who has self-only coverage, the employer must make a comparable HSA contribution for all other full-time participating employees who have self-only coverage.
HSA contributions to employee accounts by a business are typically treated as employer-provided health coverage, deductible by the business, and non-taxable to the employee. Employer contributions can be made at the beginning of the year, or periodically throughout the plan year. However, once the employer makes a contribution to an employee’s HSA, that contribution belongs to the employee; the employer has no control over the funds.
Though anyone can contribute to an HSA on behalf of someone else, only the account holder and the employer can take the tax deduction. And, while multiple contributors may make contributions to an account holder’s HSA, the maximum contribution limit does not change. For example, if an employer made a $1,000 contribution to an employee’s self-only HSA account, the employee could only contribute up to an additional $2,550 to his HSA in 2020.
Amounts contributed in excess of the annual limit cannot be deducted and will be subject to a 6 percent excise tax. The excise tax can be avoided if the excess (and any interest earned on the excess) is withdrawn from the HSA by the individual’s tax filing due date.
An HSA account holder may take withdrawals from an HSA for any purpose. This is typically done by using a credit or debit card linked to the account; many custodians also allow the account holder to submit a reimbursement request (along with proof of medical expenses), and will then send a check to the holder.
HSA withdrawals are characterized as either qualified or nonqualified.
Qualified HSA withdrawals are received tax-free by the account holder. Qualified withdrawals are taken to pay for medical expenses that would generally qualify for the medical and dental expense income tax deduction (described in § 213(d) of the Internal Revenue Code), and are not covered by the HDHP. For example, qualified withdrawals can be used to cover the deductible and copayments of the HDHP, as well as many costs that might not be covered by the HDHP. Section 213(d) qualified medical expenses are more expansive than what is typically covered by an HDHP and include items such as:
birth control pills
Braille books and magazines
contact lenses and eyeglasses
guide dog or other service animal
transportation costs associated with medical care
Over-the-counter medicines and drugs, once allowed as reimbursable HSA expenses, can now be paid with tax-free HSA funds only when they are prescribed by a physician. (The exception is insulin, which can be purchased with HSA funds without a prescription.) Out-of-network provider costs, if not covered by the HDHP, can be paid with HSA funds.
Withdrawals for Family Members
Qualified withdrawals are not limited to costs incurred by only the HSA owner. They can also be taken for medical expenses incurred by:
the owner’s spouse
any dependent (child or adult) the owner claims on his or her tax return
Qualified withdrawals for spouses and dependent children can be taken regardless of whether the spouse and children are covered by the HDHP. As long as the expenses of a spouse or children are not reimbursed by another plan, withdrawals from an HSA for their expenses can be taken tax-free.
Withdrawals for Premiums
It should be noted that premiums for the HDHP plan associated with the health savings account are not considered qualified expenses and cannot be paid with HSA funds. However, there are a few types of insurance plans whose premiums can be paid with HSA funds. No penalty or taxes will apply if HSA funds are withdrawn to pay premiums for:
qualified long-term care insurance (up to certain premium amount limits)
health insurance while the account owner is unemployed and receiving unemployment compensation
COBRA continuation coverage
Medicare Part A and Part B premiums (Though an individual cannot make contributions to an HSA once he or she is covered by Medicare, amounts can be withdrawn to pay for Medicare premiums. This allowance does not include premiums for Medicare supplement insurance.)
Unused Funds Continue to Accumulate
If the HSA account holder does not need or use all of the account funds during the plan year, the money can be left in the account from one year to the next; it is not forfeited. There is no limit on the amount that can accumulate in an HSA. In addition, the account holder can continue to make contributions to the account, as long as he or she remains covered by the high-deductible health plan. In this way, the HSA works to motivate account holders to use medical services wisely.
Neither employers nor HSA custodians can place any restrictions on how an individual uses his or her HSA funds. An HSA owner can withdraw money from the HSA for non-medical purposes; such withdrawals are called nonqualified withdrawals or nonqualified distributions. An HSA withdrawal for non-medical costs is taxed as income and a penalty of 20 percent is applied. For instance, if 52-year-old Deena withdrew $2,000 from her HSA to cover the costs of cosmetic surgery—a nonqualified expense—she would have to include the $2,000 in income that year and would be assessed a $400 penalty.
The penalty does not apply if the withdrawal occurs after the owner turns age 65, becomes disabled, or dies.
HSA withdrawals can be made for any purpose. However, once the account owner is 65 or older, nonqualified withdrawals will be taxable but will incur no penalty. (If taken for qualified medical expenses, withdrawals remain both tax-free and penalty-free.) For this reason, a person may want to keep contributing to his or her HSA as long as possible; it is another way to prepare for retirement, if medical costs do not require the use of the HSA funds. This may be attractive to individuals who regularly put aside the maximum into an IRA or other retirement fund. However, keep in mind that once a person enrolls in Medicare, he or she has “other health care coverage” and can no longer make HSA contributions.
The individual who establishes the HSA is required to track withdrawals made from the account and should maintain a record of expenses to demonstrate that withdrawals are for qualified medical expenses. Because qualified distributions are not taxable, the IRS requires the reporting of these distributions. Each year, the HSA owner will receive statements from the HSA custodian, detailing all contributions and distributions made during the year. In turn, the HSA owner must report HSA contributions and distributions on Form 8889 and submit it with his or her tax return.
HSA Advantages and Disadvantages
To summarize, HSAs offer significant advantages to account holders, including those that are tax-related as well as non-tax-related. We’ll also take a look at some disadvantages to be aware of.
Tax-Related HSA Advantages
An HSA offers tax benefits to encourage taxpayers to become savvy health care consumers. It should therefore not be surprising that many of the HSA advantages are tax-related. The principal tax-related HSA advantages include the following:
An employee’s personal HSA contributions may be made with pre-tax funds, which reduce the employee’s federal taxable income by the amount personally contributed.
An employer’s HSA contributions on behalf of employees are federally tax-deductible to the employer and are not includable in the employees’ income for tax purposes.
Most states permit HSA account holders to reduce their state taxable income by the amount of an HSA contribution.
Neither HSA contributions made on a pretax basis by an employee nor HSA contributions made by an employer are subject to various payroll taxes, including:
o Social Security taxes
o Medicare taxes
o federal unemployment taxes
o Railroad Retirement Act taxes
o state unemployment taxes in most cases
HSA earnings grow on a tax-deferred basis.
HSA distributions are tax-free when used for qualified medical expenses.
Non-Tax-Related HSA Advantages
HSAs also offer significant non-tax advantages, including the following:
No “use it or lose it” principle applies. Accordingly, unused HSA balances remain in the account from one year to the next and are available when needed.
The HSA is both portable and nonforfeitable and, accordingly, remains with the account holder, even if the employer made all contributions and the employee changes employers or retires.
An HSA account holder may transfer the HSA from one custodian to another when desired.
An HSA is owned by the account holder who may use the funds as desired, even for nonmedical reasons. (However, HSA funds taken for nonmedical purposes are subject to taxation as ordinary income and are subject to a tax penalty.)
Both the account holder and his or her employer can contribute funds to an HSA. If made by the employer, the contributions are not includable in the account holder’s gross income for tax purposes.
Like many other financial products and transactions, HSAs also involve certain possible disadvantages. These disadvantages are most evident when an HSA is compared with traditional health plans that may involve little or no deductible. The potential disadvantages of an HSA and HDHP combination as an approach to providing appropriate insurance coverage include the following:
HDHP deductibles that an insured is responsible for before any health plan benefits are payable are higher—often, substantially higher—than under traditional health plans and present an additional cost burden.
Because HSA balances require time to build up to a point at which they are sufficient to provide funds for all out-of-pocket medical expenses, an HSA account holder may be presented with large medical expenses for HDHP deductibles and coinsurance before there is enough money in the HSA to pay them.
Because an HSA is designed to encourage an account holder to become an increasingly savvy health care consumer, having an HSA and selecting appropriate health care providers and services is likely to take the account holder longer and require more effort than might be required if the individual were covered under traditional health insurance.
HSA account holders must report HSA contributions and distributions each year on their income tax returns.
Although the HSA rules are not terribly complex, an account holder must learn and follow the rules to avoid possible unexpected tax consequences.
Being an HSA account holder requires that the individual maintain it, which involves:
o paying medical bills
o monitoring the HSA balance
o selecting beneficiaries
o performing any other task to ensure the continued sufficiency of the HSA