How Does a Health Savings Account Work?

An HSA, or Health Savings Account, is a special type of tax-advantaged savings account designed to help you pay for out-of-pocket medical expenses. In order to make contributions to an HSA, you must be enrolled in an HSA-qualified high-deductible health plan, or HDHP. In addition to being a smart way to pay for out-of-pocket medical expenses like your deductible and coinsurance, HSAs are increasingly being used as part of a retirement-planning strategy.

However, because of the tax-advantages, there are lots of rules about who is allowed to start an HSA, who can contribute money to an HSA, and what that money can be used for. If you don’t follow the rules, you’ll lose the tax advantages and owe additional penalties.

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How Does an HSA Lower My Taxes?

If you manage your HSA correctly and follow all of the IRS rules, your HSA money is:

  • Not taxed when you earn it and put it into the HSA.
  • Not taxed as it grows (via investment earnings or interest).
  • Not taxed when you take it out of the HSA to pay for medical expenses.

Here’s how it works. The money you put into your HSA is pre-tax. If your employer contributes to your HSA, that money isn't counted as income so you're not paying taxes on it, either.

Interest and investment earnings in your HSA grow tax-deferred like they do in an IRA. Since you’re not paying income taxes each year on the growth, you keep more of that money in the account, and the account grows faster. And there's no "use it or lose it" rule for HSAs. If you don't need to withdraw the money to pay for medical expenses, it just remains in the account and rolls over from one year to the next. So it's possible to amass a significant nest egg in an HSA if you make consistent contributions and don't need to make withdrawals.

If you take money out of your HSA to pay for qualified medical expenses, you don’t have to pay income taxes on it. However, if you take money out of your HSA but don’t use it for medical expenses, you’ll have to pay income taxes on it plus a 20% penalty (this used to be 10%, but the Affordable Care Act increased it to 20%).

After you turn 65 years old, the rules are a little different. If you’re on Medicare, you can’t contribute to your HSA anymore. However, you can still use the money you’ve saved in your HSA. Unlike before you turned 65, you can spend your HSA money on anything you want and you won’t have the 20% penalty. However, you’ll have to pay income taxes on HSA withdrawals not used for medical expenses. If you take money out of your HSA and use it for qualified medical expenses, you don’t pay regular income taxes on it; it’s totally tax-free.

Who’s Eligible for an HSA?

You’re eligible to start and contribute to an HSA if you meet all of these requirements:

  1. You’re covered by a qualified HDHP [This is not just any health plan with a high deductible. You need to have a high deductible health plan that meets the deductible and out-of-pocket requirements established by the IRS for HSA-qualified plans, and that doesn't cover anything besides preventive care before the deductible is met—ie, you'll pay the full cost of office visits, rather than just a copay, until you've met your deductible. The IRS has relaxed the rules a bit in terms of what services can be considered preventive care and thus paid by an HDHP pre-deductible, and has also relaxed the rules to allow HDHPs to pay for COVID-19 testing and treatment pre-deductible. ]
  2. You don’t have additional, non-HDHP health insurance coverage.
  3. You aren’t on Medicare.
  4. Nobody else can claim you as a dependent on their tax return.
  5. You don't have a general-purpose flexible spending account (FSA) or health reimbursement account (HRA). You can have a limited-purpose FSA or HRA, a post-deductible FSA or HRA, a retirement HRA, or suspended HRA

How Does Money Get Into the HSA?

You can contribute money to your HSA yourself, your employer may contribute money to your HSA, or another person may contribute money to your HSA. However, the total yearly contributions to your HSA are limited. The limits change each year and vary based on your age and whether you have self-only HDHP coverage or family coverage.

How Much Can You Contribute to an HSA?
  2019 2020
Self-only coverage under age 55 $3,500 $3,550
Family coverage under age 55 $7,000 $7,100
Self-only coverage age 55+ $4,500 $4,550
Family coverage age 55+ $8,000 $8,100
Yearly HSA Contribution Limits

If your HDHP health insurance coverage is through your job, your employer might make contributions to your HSA. Additionally, many employers set up payroll deductions so you can easily contribute a portion of each paycheck directly into your HSA. When HSA contributions are made this way, you avoid both income tax and payroll tax (FICA), whereas non-payroll contributions to an HSA are only deductible for income tax purposes (you deduct them on your tax return in that case).

If your health insurance isn't through your job, your employer probably won't be involved. In this case, some people choose to make automatic monthly contributions to their HSA. However, your financial institution will also allow you to make a lump-sum contribution to your HSA if you prefer that approach. And even if your HSA is established through your job, you can stop, start, or change your HSA contribution amounts at any time. This differs from FSA contributions, which can't be changed mid-year unless you have a qualifying event.

Your HSA funds need to be with an HSA custodian, which can be a bank, credit union, insurance company, or brokerage. The option to have your money in a brokerage account means that it can be invested in the stock market if that's your choice, earning investment returns rather than simple interest (investments are subject to risk, which is why some people prefer the lower returns—and lower risk—that go along with keeping HSA funds in a bank or credit union).

You may be able to fund your HSA with a distribution from your traditional or Roth IRA. The distribution must be made directly by the trustee of the IRA to the trustee of the HSA and is only allowed once in your lifetime. Learn more about this from IRS Publication 969 or your financial advisor.

As with your IRA, you may contribute to your HSA through April 15th of the following year (or the tax filing deadline for that year, if it's shifted slightly from April 15). For example, if you have HDHP coverage in 2020 but don’t max-out your 2020 HSA contributions by the end of the year, you may make an additional 2020 contribution as you’re preparing your taxes on April 15, 2021. Or you can choose to make the entire 2020 contribution on April 15, 2021—it's up to you. [Note that the tax filing deadline for 2019 returns has been extended to July 15, 2020 due to the COVID-19 pandemic, which means people have until July 15, 2020 to make 2019 HSA contributions. ]

How Can I Use My HSA Funds?

The money in your HSA is yours. You can spend it on whatever you wish. However, if you want to avoid paying income taxes and penalties on it, you’ll only take a distribution from your HSA to pay for eligible medical expenses.

Eligible medical expenses include medical expenses your health insurance doesn’t pay for, but that would otherwise be eligible to be taken as a deduction on your federal income taxes (if you use money from your HSA to pay these expenses, however, you cannot deduct them on your tax return, since that would be double-dipping). See the entire list in IRS Publication 502, but here’s a synopsis:

  • Your health insurance deductible, copayments, and coinsurance (you must have HDHP coverage in order to make contributions to an HSA, and you can use those HSA funds to pay your out-of-pocket expenses under the HDHP. If you later transition to a non-HDHP and still have money remaining in your HSA, you can use that money to pay the out-of-pocket costs you incur under your new health plan, although you won't be able to make additional contributions to your HSA unless you transition back to an HDHP).
  • Prescription medications and over the counter medications. From 2011 through 2019, over the counter medications could only be purchased with tax-free HSA funds if you had a prescription for them, but the CARES Act—a bill primarily focused on COVID-19—eliminated that requirement, allowing people to use tax-free HSA funds to purchase over-the-counter medications. Medical marijuana isn’t eligible even if you have a prescription and are in a state where it’s been legalized.
  • Dental expenses like teeth cleanings, preventive care, and fillings. However, purely cosmetic dentistry like teeth whitening isn’t eligible.
  • Eye exams, vision correction surgery, glasses, contact lenses, and contact lens supplies as long as the glasses or contacts are used for medical reasons like vision correction.
  • Menstrual products (this is a new addition, added by the CARES Act in 2020)
  • Breastfeeding supplies.
  • Diabetic supplies.
  • In vitro fertilization expenses.
  • Alternative medical care your health insurance may not cover such as acupuncture treatments, chiropractic care, and medical care provided by a Christian Science practitioner.
  • The premium for COBRA continuation of your health insurance, your spouse’s health insurance, or your dependents’ health insurance.
  • The premium for long-term care insurance (subject to dollar limits that vary based on your age and are indexed by the IRS each year).
  • The premium for health insurance while you’re receiving government unemployment compensation.
  • If you're 65 or older, the premium for Medicare Parts A, B, and D, or Medicare Advantage. However, Medicare supplement insurance (Medigap) isn’t an eligible expense.

Even though your HSA is technically an individual account, you may use it to pay for the eligible medical expenses of your spouse and your tax dependents, also.

What Else Do I Need to Know?

You’ll need to file an additional tax form, Form 8889, any year you, your employer, or someone else contributes to your HSA. Even if nobody contributed to your HSA, you’ll need to file form 8889 if you withdrew money from your HSA.

The bank or brokerage that you use as an HSA custodian will send you up to two tax forms each year. Form 5498-SA will show your HSA contributions for the year. Form 1099-SA will show withdrawals from your HSA for the year (if you had any).

You'll need to save sufficient documentation that you were spending any HSA withdrawals on eligible medical expenses. If the IRS audits your return, you may have to produce things like doctor's bills, health insurance explanation of benefits forms, and receipts for things like contact lens solution and Band-Aids.

Thinking of gaming the system by hopping into an HDHP for a few months so you can contribute an entire year’s worth of tax-free money into an HSA, only to hop back out of the HDHP a few months later? Don’t bother. The IRS has a testing period that lasts from December of the year you took the deduction through the entire next year. If you don't maintain coverage by a high-deductible health plan during the entire testing period, you’ll lose the tax advantage and could be subject to a penalty. However, if you plan on maintaining HDHP coverage, you needn’t worry about the testing period.

So if you enrolled in an HSA-qualified plan in October 2019 and you're going to continue to have an HSA-qualified plan throughout all of 2020, you're allowed to make the full 2019 and 2020 contributions to your HSA. But if you terminate your HDHP enrollment mid-year in 2020, you'll have to add the amount you contributed to your HSA for the first nine months of 2019 (when you didn't have HDHP coverage) to your 2019 income, plus an additional 10% tax. 

Healthcare Reform and HSAs

Most Republican healthcare reform proposals call for an increased emphasis on HSAs, including higher contribution limits, loosening of the eligibility guidelines in terms of who can make contributions, and tax credits to help people fund HSAs.

On the other hand, the Medicare for America Act, which was introduced in the House in late 2018 and is supported by many Democratic members of Congress, calls for HSA contributions to cease, since the bill would greatly reduce exposure to large medical bills for many Americans.

Clearly, the two sides of the aisle take differing views on HSAs. But for the time being, HSA rules are unchanged.

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Article Sources
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  1. Internal Revenue Service. Publication 969: Health Savings Accounts and Other Tax-Favored Health Plans (Cat. No. 24216S). Updated March 6, 2019.

  2. Internal Revenue Service. Publication 502 (2019), Medical and Dental Expenses.

  3. U.S. Centers for Medicare & Medicaid Services. Read the Affordable Care Act (Section 90040).

  4. Internal Revenue Service. Notice 2019-45. Additional Preventive Care Benefits Permitted to be Provided by a High Deductible Health Plan Under § 223.

  5. Internal Revenue Service. Notice 2020-15. High Deductible Health Plans and Expenses Related to COVID-19.

  6. Internal Revenue Service. Internal Revenue Bulletin No. 2019-22. Published May 28, 2019.

  7. Optum Bank. 2019 HSA contribution deadline extended to July 15, 2020 due to COVID-19.

  8. Internal Revenue Service. Publication 502: Medical and Dental Expenses (Cat. No. 15002Q). Updated November 5, 2019.

  9. H.R.748. Coronavirus Aid, Relief, and Economic Security Act” or the “CARES Act." Enacted March 27, 2020.

  10. Internal Revenue Service. Form 8889 (Cat. No. 37621P). Updated November 5, 2019.

  11. Internal Revenue Service. Form 5498-SA (Cat. No. 38467V). Updated November 5, 2019.

  12. Internal Revenue Service. Form 1099-SA (Cat. No. 38471D). Updated November 5, 2019.

  13. U.S. House, 115th Congress, 2nd Session. H.R. 7339 - Medicare for America Act of 2018. Published December 19, 2018.