What is a health savings account? It is a tax-preferential way to save for health and medical costs. The IRS allows two different ways for individuals and families to save tax-free for certain health- or medical-related expenses: the health savings account (HSA) and the flexible savings account (FSA). HSAs and FSAs have many things in common, but they also have important differences.
Which account is “right” for you depends on the type of health insurance you have.
Both the HSA and the FSA have valuable tax advantages for any family that pays income taxes.
Underlying health insurance
If your health insurance plan is a Health Maintenance Organization (HMO) or a Preferred Provider Organization (PPO), you can only use the FSA. If your health insurance is a qualified High-Deductible Health Plan (HDHP), you SHOULD use the HSA. If you don’t know what type of health insurance plan you have at work, ask your human resources department – they will know.
Is an FSA the same as an HSA? No. But they have some features in common.
For BOTH the HSA and the FSA…
- The IRS allows individuals to contribute pre-tax dollars to a savings account. If you use the savings account for qualified health or medical expenses, you can withdraw from the account tax-free.
- To understand the power of tax-free, look at your marginal tax rate – the rate at which your next dollar of income will be taxed; for most Americans, this is between 12% and 22%. If your marginal tax rate is 22%, for every dollar you put in an HSA or FSA, it is the equivalent of you putting in 78 cents and the IRS putting in 22 cents (because you won’t pay federal income taxes on the amount put in the savings account). So, you would get a 22% discount on everything you purchase and reimburse yourself through the HSA or FSA! Pretty good, huh?
- Many employers offer these savings plans through a convenient payroll deduction, and if you leave your employer, you can take these savings accounts with you – you do not forfeit your savings. (If your employer doesn’t offer these savings accounts, you can sign up for them in the open market – just search for HSA or FSA providers.)
- The account holder is usually given a debit card that can be used at the doctor’s office or pharmacy to directly pay for qualifying expenses – no out-of-pocket payment is necessary in this case.
- Qualified expenses include extensive medical, prescription, dental, and vision costs. Many over-the-counter expenses are also qualified expenses. The IRS provides a detailed list of qualified expenses, but this list is somewhat easier to read.
Health Savings Accounts (HSA)
According to the IRS, an HSA is only available if you have a high-deductible health plan.
In 2022, an individual can contribute up to $3,650 (a family can contribute up to $7,300). Two unique aspects of the HSA plan are that your employer can also contribute to this health/medical savings account (and many do!), and you can carry the unused balance in the account over each year. These are both very powerful benefits, and they allow participants to “save up” their “high-deductible” in the HSA while also receiving tax benefits.
Another advantage of the HSA is that, once your financial life is “mature,” you can usually invest some of your HSA savings in the market, potentially earning market returns. This would be most useful after you have paid off all of your debts and have saved a fully-funded emergency fund. This is particularly beneficial because you can keep your HSA savings into retirement to be used tax-free for medical expenses – so this account can act like a “medical Roth account.”
Flexible Savings Accounts (FSA)
According to the IRS, an FSA is available if you have any health insurance plan. However, certain features of the HSA vs. the FSA make the FSA less desirable. So, most people who use an FSA do NOT qualify for an HSA (they do not have a high-deductible health plan).
Relative to the HSA, the FSA has a few critical disadvantages. First, the FSA has a lower contribution limit: $2,850 in 2022. Second, the FSA does not carry over year to year but, instead, has a “use it or lose it” policy. (During Covid, the IRS has allowed some year-to-year carryover for FSA accounts, but that was not the case pre-Covid and may not be available as the Covid national emergency ends).
Can you have an FSA and an HSA?
If you have an HSA, there are some reasons why you might ALSO want to use an FSA – if you are interested in that (admittedly limited topic), let me know in the comments, and I’d be glad to teach more on that topic.
Important Take-Aways
Both the HSA and the FSA have valuable tax advantages for any family that pays income taxes.
A surprising number of expenses are eligible to be paid with tax-free dollars through an HSA or FSA account. Therefore, with proper planning, individuals and families can have a 12%, 22%, or even higher discount when purchasing health or medical items through a health savings account.