What Are Health Savings Accounts and How Do They Work?

Health savings accounts can be an underused but vital tool for covering the cost of medical expenses. Health savings accounts, or HSAs, can allow you to set aside money to help pay for certain healthcare expenses. [Duration- 1:45]

Health Savings Accounts (HSAs) are common, specialized savings tools that can help pay for expenses not otherwise covered by health insurance. While HSAs generally won't negate the need for medical and prescription drug coverage, when utilized to their full potential, they can offer valuable support in the face of health care debt.

What is an HSA?

According to the IRS, an HSA is a tax-exempt trust or custodial account you set up with a qualified HSA trustee (which might be a bank, an insurance company or an IRA manager) to pay or reimburse you for qualified medical expenses. You must meet certain qualifications, outlined below, to open and fund an HSA.

Once you've set up an HSA, you may contribute a portion of your pre-tax income to the account. You may also make investments with these funds. Unlike “use it or lose it” flexible spending accounts (FSAs), anything that isn't spent on medical expenses may be kept in the account (and invested, if you choose) and rolled over from year to year. These funds can then be used to help cover future qualified medical expenses.

Because HSA contributions are excluded from your income and are not subject to federal income tax, the account earnings grow tax-free and generally faster than they would in a traditional savings or brokerage account.

You can read more about HSAs on Healthcare.gov here. It's also important to remember that not all medical treatments can be paid for with HSA funds. To learn more, check out this IRS page, under the header “What Are Medical Expenses?” When it comes to medications, the IRS specifies that a medicine or drug will be a qualified medical expense for HSA purposes if it requires a prescription or is available over the counter but you have a prescription for it. Insulin is also considered a qualified medical expense.

In order to be eligible to open and contribute to an HSA, you need to be enrolled in a high-deductible health plan (HDHP). Often, deciding if an HSA is right for you means thinking about whether an HDHP is right for you.

What exactly is an HDHP?

A high-deductible health plan is a type of medical insurance that is increasingly offered by employers. Essentially, you pay lower premiums but have significantly higher deductibles. The intent is to provide coverage in case of a catastrophic illness or other high-cost treatment, but you're on the hook for most smaller expenses until you've met your annual deductibles.

For 2021, the deductibles, copays and other out-of-pocket expenses (excluding premiums) that you'll incur with an HDHP may be up to $7,000 for self-only coverage and up to $14,000 for family coverage, according to the IRS.

HSAs allow you to set aside pre-tax earnings that you can then use to pay these deductibles and any qualified medical expenses that aren't covered by your HDHP. There are no income limits on who is eligible to utilize an HSA; however, there are caps on how much you can contribute annually. According to the IRS, for 2020, if you are enrolled in an HDHP, you can contribute up to $3,550 for self-only coverage and up to $7,100 for family coverage into an HSA. In 2021, you will be able to contribute up to $3,600 for self-only coverage and up to $7,200 for family coverage. A catch-up provision, which allows you to contribute an additional $1,000 annually to an HSA, is available to those who are at least 55 years old.

As HSAs continue to gain popularity with employers, they are becoming accessible to more Americans. Our best financial decisions are often driven by how we consider our future. Because your balance rolls over from year to year and you can invest the funds for growth, HSAs may be a valuable tool to help you pay for medical expenses today while contributing to your long-term financial stability.