HSAs provide a tax-free way to pay for medical expenses

Executive summary:

HSA Overview

Health savings accounts (HSAs) have grown in popularity since they were first introduced in 2004; however, many individuals are still unaware of the triple tax benefits available with these accounts. HSAs are the only investment vehicles that provide tax-free contributions, earnings and distributions to pay for medical expenses. These personal accounts also offer opportunities for individuals to accumulate funds for their retirement years.

This article provides an overview of HSAs and their tax benefits for individuals. For a discussion of some of the advantages to employers of offering HSAs to employees, check out this related article.

Tax-free contributions

The first tax advantage of HSAs is that contributions to the account are tax-free if certain requirements are met. In order to contribute to an HSA, an individual must be enrolled in a high-deductible health plan (HDHP). The HDHP must meet certain limits on deductibles and out-of-pocket expenses based on whether it is self-only coverage (for one person) or family coverage (for more than one person). To be eligible for an HSA, an individual cannot be enrolled in other non-HDHP coverage, such as a general-purpose health reimbursement account (HRA) or health flexible spending account (FSA) or in Medicare.

There are three ways that tax-free contributions can be made to HSAs:

• Employees can make pretax HSA contributions via payroll deductions, if allowed by their employer. These payroll deductions are not subject to federal income tax, Social Security or Medicare (FICA) taxes or most state income taxes. Generally, employees can start, modify or stop HSA contributions at any time during a year.
• Employers can make contributions directly to their employees’ HSAs. These contributions are not treated as taxable income to the employees and thus are exempt from income and payroll taxes. Typically, employers will make their contributions ratably throughout the year.
• Individuals can make contributions from their personal funds and deduct the contributions on their individual income tax returns. To be deductible for a given tax year, contributions must be made during the year or by April 15 of the following year.

The amount that can be contributed on a tax-free basis to an HSA for a year is limited based on the account owner’s months of HSA eligibility and type of HDHP (self-only or family). Special rules apply in determining the contribution limits for a married couple. Spouses enrolled in an HDHP cannot have a joint HSA, but each spouse can have a separate HSA and contributions can be allocated between the HSAs. Individuals aged 55 or over are entitled to an additional catch-up contribution of $1,000. In a married couple, if both spouses are age 55 or over, each spouse can contribute a $1,000 catch-up contribution to his or her own HSA.

The account holder is responsible for ensuring that the contribution limit is not exceeded. Excess contributions are subject to taxes, plus an additional six percent excise tax. All contributions made to an HSA for a year are aggregated when determining if the IRS limit is exceeded and are reported on Form 8889 attached to the account holder’s individual income tax return (Form 1040).

The IRS limits on contributions and HDHPs are adjusted annually for inflation, and the chart below summarizes the current limits:

Tax-free investment earnings

The second tax advantage of HSAs is that the investment earnings inside the account are not subject to income taxes while held in the account. Furthermore, if the investment earnings are withdrawn to pay for medical expenses, they are never taxed.

HSAs are simple to set up and most financial institutions offer HSA trust and custodial services. These financial institutions typically provide a wide variety of investment options for HSA funds, and the funds carry over from year to year.

Furthermore, the health savings account always belongs to the account holder. Even if the account is set up through an employer, the account is the property of the employee. Thus, if the employee terminates employment with the employer, the HSA funds are not forfeitable. Typically, the employee can continue to maintain the HSA with the same financial institution.

Tax-free distributions

The third tax advantage of HSAs is that distributions for qualified medical expenses incurred by the account holder after the HSA is established are tax-free. The account holder can also withdraw HSA funds on a tax-free basis for qualified medical expenses of a spouse or tax dependent.

In general, qualified medical expenses for HSA purposes are the same types of medical expenses deductible on Form 1040, Schedule A, as discussed in IRS Publication 502, Medical and Dental Expenses. Physician and hospital services, long-term care services, medical equipment and supplies (including menstrual care products) and medicines and drugs typically are qualified medical expenses. Health insurance premiums are not qualified medical expenses unless they are for COBRA or USERRA continuation coverage, long-term care or coverage while the individual is receiving unemployment compensation. Individuals over age 65 can use HSA funds on a tax-free basis to pay premiums for certain retiree coverage or Medicare, but not for Medicare supplemental policies.

If a distribution is taken from an HSA for an expense that does not meet the requirements for a qualified medical expense, the distribution is taxable. Furthermore, the distribution is subject to an additional 20 percent penalty tax unless it is made after the account holder turns age 65, becomes disabled or dies.

The account holder is responsible for determining whether a distribution is for a qualified medical expense and must report the nature of the distribution (tax-free or taxable) on Form 8889 attached to Form 1040. Therefore, the account holder should maintain records of all qualified medical expenses in order to support the tax-free treatment of distributions.

With regard to the timing of HSA distributions, an account holder is permitted to take distributions from the account at any time. Therefore, an account holder could take multiple distributions from the HSA in a given year. Alternatively, the account holder could delay distributions and allow the HSA funds to accumulate for many years since there is no time limit on when distributions must begin. Unlike retirement plans or IRAs, there is no requirement that distributions from an HSA begin at a certain age. Furthermore, an HSA owner could take tax-free distributions in the current year for qualified medical expenses incurred in prior years after the HSA was opened, as long as proper documentation of the expenses is maintained, the expenses were not previously deducted on Form 1040 and were not reimbursed by another source.

Tax planning tips

Health savings accounts offer a unique tax savings opportunity since (1) contributions are tax-free (within limits); (2) investment earnings are tax-free; and (3) distributions are tax-free if used for qualified medical expenses.

In order to maximize the tax benefits of health savings accounts, individuals should consider implementing the following tax planning tips:

• Contribute the maximum allowed amount to the HSA each year. When trying to fund both an HSA and a 401(k)-retirement plan, consider contributing enough to each arrangement to receive the full employer matching contribution (if any). Then contribute up to the maximum in the HSA before making further contributions to the 401(k). Although both HSA and 401(k) contributions are exempt from income taxes, only HSA contributions have the added benefit of being exempt from Social Security and Medicare (FICA) taxes, thus generating an additional immediate tax savings. Furthermore, unlike with a 401(k), an individual has complete control over the timing and dollar amount of distributions from an HSA, thus making it a flexible investment tool.
• Leave HSA dollars in the account to grow tax-free and pay current medical expenses with other funds. Unfortunately, most individuals use an HSA as a checking account and take distributions shortly after making contributions, thus failing to reap the benefit of tax-free earnings. If possible, delay taking distributions from the account and invest for the long-term to take advantage of potentially higher investment returns.
• If under age 65, only take distributions from the HSA for qualified medical expenses so that the distributions are exempt from tax and the additional 20 percent penalty. If over age 65, the additional 20 percent penalty no longer applies, so distributions taken for nonqualified medical expenses are only subject to normal income taxes, the same as many retirement plan distributions. Hence an HSA, like a 401(k) or IRA, can be viewed as another funding source for retirement living expenses. Of course, distributions after age 65 for documented qualified medical expenses are still tax-free. So, the best tax strategy, regardless of age, is to only use HSA funds for qualified medical expenses. Save records of all qualified medical expenses so that tax-free distributions can be taken in either the current year or future years for expenses incurred today.

Health savings accounts are a valuable tool for saving money for medical expenses since they offer a triple tax benefit via tax-free contributions, tax-free investment earnings, and tax-free distributions. For more information about HSAs, see IRS Publication 969, Health Savings Accounts and Other Tax-Favored Health Plans.

"Originally published April 13, 2023, updated to reflect 2024 limits."