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How Do HSAs Work?

How Do HSAs Work?

Health savings accounts (HSAs) are hands-down the best medical savings accounts on the market. But if you don’t fully understand how HSAs work, you may be missing out on their wonderful tax-saving features. Here’s the lowdown on all things HSA:


What Is An HSA?

An HSA is a savings and investment account used to pay for or reimburse qualified medical expenses. Your money goes in tax-free or tax-deductible (depending on how you contribute it), and you can withdraw funds tax-free when you have a qualified medical expense. Or, you can let the funds in your account grow tax-free and invest them.

You can think of an HSA as a bigger-and-better FSA because it stays with you when you switch jobs and doesn’t have any use-it-or-lose-it restrictions. But HSAs can also be used to invest for retirement like a medical 401(k). With more tax benefits than any other savings vehicle, HSAs are the perfect choice for anyone who wants to save money on current or future medical expenses.


The First Step: Eligibility

To be able to make HSA contributions, you must be covered under an HSA-qualified high deductible health plan (HDHP), as well as meet other eligibility requirements set by the IRS. Basically, these requirements make sure you’re not covered by other disqualifying healthcare plans or programs, like Medicare or an FSA. Learn more about HSA eligibility requirements here.


OK, I’m Eligible. Now What?

You’re free to start contributing funds to your HSA! There are a few ways to contribute to your HSA, but the best way is by having your employer withhold funds from your paycheck. When you do that, not only are the contributions exempt from federal and state taxes (in almost every state), you also don’t have to pay FICA taxes on them.

If your employer doesn’t have payroll withholding set up, you can also contribute to your HSA after-tax. If you do, you can deduct that contribution amount on your tax return, but you’re responsible for the FICA taxes. Also, anyone can contribute to your HSA, and if anyone besides your employer does contribute, you get the tax deduction for those contributions.


How Much Can I Contribute?

The IRS sets annual limits on how much you can contribute to your HSA each year. If you go over the contribution limit, you’ll need to remove those excess contributions or face a tax penalty. For 2021, the contribution limits are $3,600 if you have self-only health coverage (you’re the only one covered) and $7,200 if you have family health coverage (at least one other person is covered besides you). In addition, once you’re 55 you can contribute an extra $1,000 to your HSA annually as long as you’re HSA-eligible.


What Happens If I Lose HSA Eligibility?

If you lose HSA eligibility, you’ll need to prorate that year’s contributions for the months you were eligible. If you were eligible for 8 months in the year, you’d multiply your annual contribution limit by 8 (the number of months you were eligible) and divide by 12 (total months in the year). That’s your prorated contribution limit. Also, you won’t be able to make any additional contributions unless you become eligible once again.

However, any funds you have in your account are yours to spend, even if you aren’t HSA-eligible. You never lose the ability to withdraw funds from your HSA.


What Can I Pay For With My HSA Funds?

You can use your HSA to pay for or reimburse qualified medical expenses tax-free. You can pay for an expense when it occurs, or you can reimburse yourself for an earlier expense, as long as it was incurred after you opened your HSA.

Generally, a qualified expense is anything prescribed by a doctor for a medical condition that returns you to a normal state of health (like doctor bills, prescriptions, eyeglasses, or fillings). Certain insurance premiums are also eligible, like qualified long-term care premiums and COBRA. And although you’re not eligible for an HSA if you’re enrolled in Medicare, you can use existing HSA funds to pay for your or your spouse’s Medicare premiums once you turn 65. See a thorough list of qualified medical expenses or browse the IRS’ list here.

You can withdraw HSA funds for pay for non-eligible expenses at any time, for any reason. You’ll just need to include those withdrawals as taxable income in the year you made them, and they’ll be subject to ordinary income tax plus a 20% penalty if you are under age 65 and not disabled. Once you’re 65, however, the 20% penalty on non-eligible expenses disappears, and you just pay regular income taxes on non-eligible withdrawals.


Whose Expenses Can I Pay For With My HSA Funds?

You can use your HSA funds to pay for or reimburse qualified medical expenses for yourself, your spouse, and your tax dependents tax-free. Your spouse and tax dependents don’t have to HSA-eligible for you to pay for their qualified medical expenses; they don’t even have to be on your health insurance.


Do I Have To Use My HSA Funds Right Away?

Unlike FSAs, HSAs don’t have any use-it-or-lose-it restrictions; you can let your funds grow year-over-year if you’d like. This means you can let them accumulate interest tax-free (in almost all states), then withdraw them once they’ve grown. If you have the ability to pay for qualified medical expenses out of pocket, investing your HSA funds is a great way to build your funds for medical expenses in retirement, so you don’t have to pull funds from your 401(k) to pay for them.

Remember, your 401(k) funds are taxed when you withdraw them in retirement. So, if you paid for qualified medical expenses with 401(k) funds, you’d have to pay taxes up top of the expenses themselves. By building a retirement medical nest egg with your HSA, you can pay for those future healthcare costs tax-free and save thousands of dollars. 


Shoeboxing: The HSA Investment Secret

If you invest your HSA and pay for qualified medical costs out of pocket, you’ll want to archive your receipts in a shoebox or app to prove they were eligible expenses. There’s no limit on when you have to reimburse yourself for a qualified medical expense, so you can let your HSA grow for years or even decades, then withdraw money once your HSA has matured. And the best part is, you can use those reimbursed HSA dollars on anything you want; they don’t have to be spent on medical expenses. We call it shoeboxing.


HSAs: A Visual Breakdown


Hopefully, you now have a better understanding of how HSAs work and why they’re such valuable medical savings vehicles. If you don’t currently have an HSA, we can get you signed up today. Enrollment is quick and simple; don’t wait to start taking advantage of HSAs’ wonderful tax savings!


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