How Health Savings Accounts Work

Health savings accounts are a great addition to a high deductible health plan.
Health savings accounts are a great addition to a high deductible health plan.

Employer-sponsored health insurance used to be the gold standard for health care coverage in the United States. Your employer paid the majority of the monthly premium and you — and notably, your family — received world-class health care at a relatively low cost.

But an unsettling trend has surfaced in recent years: Deductibles have been going up — way up. As with any type of insurance, the deductible is the amount you must pay out of pocket before your coverage kicks in. In 2009, the average deductible for employer-sponsored health insurance was $826 per worker. In 2014, the average deductible was $1,217, an increase of 47 percent in just five years [source: Kaiser Family Foundation].



One reason for the dramatic increase in deductibles can be attributed to the popularity of high deductible health plans (HDHPs). With health insurance, the higher the deductible, the lower the monthly premium. For relatively healthy people on a tight budget, a low premium is the highest priority. If that means a $5,000 deductible, so be it. In response to worker demand, 81 percent of large U.S. employers plan to offer an HDHP in 2015, and 32 percent said that they will exclusively offer a high-deductible plan [source: National Business Group on Health].

But what happens when there's an unexpected medical emergency, like a serious injury or surgery? Now you have to pay that $5,000 deductible out of pocket, maybe more. As a nation, we're fairly lousy at saving money for a rainy day. The personal savings rate as of August 2014 was 5.4 percent of personal disposable income. That's up from a pitifully low 1.9 percent in July 2005, but down considerably from the double-digit savings rates of the 1960s and 1970s [source: Federal Reserve Bank of St. Louis].

Luckily, there's a solution. In 2003, Congress passed a bill creating the health savings account (HSA), a tax-free way for employees to save money for out-of-pocket medical expenses. Keep reading to learn more about the benefits of HSAs.

In order to entice more Americans to save money for out-of-pocket medical expenses, Congress designed the health savings account to be triple tax-free. Here are the three ways in which HSA contributions are protected from taxes:

1. Contributions are "pretax."



Similar to a 401(k) or Roth IRA retirement savings plan, any money you contribute to your HSA account is deducted from your taxable income. When it comes time to file your income taxes, you can claim HSA contributions as a deduction on your 1040 form, even if you don't itemize deductions [source: IRS]. Likewise, you can have HSA contributions automatically deducted from each paycheck on a pretax basis. If your employer also contributes to your HSA, those payments are not considered taxable income.

2. Interest and earnings are tax-free.

HSAs are hybrid accounts. If you want, all of your money can be held in a money market-style account that's 100 percent liquid. Your HSA provider can even issue you checks or a debit card linked to the account. Interest on those money market accounts is minimal, but it's not taxable. Your other option is to divert some of that cash into managed investments — mutual funds, stocks — just like a 401(k). Those funds are harder to withdraw (and there are transfer fees), but any earnings from those investments are also tax-free [source: Mann].

3. Distributions are tax-free for qualified medical expenses.

The whole point of HSAs is to encourage people to save money for medical expenses. As long as you use HSA funds to pay for medical expenses, all withdrawals are tax-free. The IRS publishes its list of qualified medical expenses in Publication 502 and includes everything from acupuncture to organ transplants, but not insurance premiums or nonprescription drugs. If you spend HSA funds on nonmedical expenses or withdraw the money to close the account, you will not only pay income tax on the amount, but also a 20 percent penalty [source: IRS].

Beyond the triple tax break, HSAs have other advantages over similar savings plans like flexible spending accounts (FSAs). With an FSA, you have to spend all of the money in your account by the end of the calendar year or it disappears. With an HSA, however, you can roll over all unused funds to the next year [source: Waldrop].

Another huge benefit of HSAs is that they are completely portable, meaning the account isn't tied to a particular job. You can switch employers, become self-employed or move all the way across the country and your HSA will follow you. That's because HSAs are offered by commercial banks and other investment companies, not employers.

Before you get too excited about HSAs, let's see if you're eligible. Learn all about the HSA rules on the next page.

The tax benefits of health savings accounts are amazing, so why aren't we all signed up? Because the IRS has strict rules about who is eligible to use HSAs. Here are the most important criteria for HSA eligibility:

  • You must be enrolled in a high deductible health plan (HDHP) with no other health coverage.
  • You cannot be enrolled in Medicare.
  • You cannot be claimed as a dependent on anyone else's tax return.

First things first, what qualifies as a HDHP? An HDHP, according to the IRS, must have both a higher-then-average deductible and a high out-of-pocket limit. Here are the eligibility rules for tax year 2014:



  • Minimum annual deductible: $1,250 for single coverage, $2,500 for family coverage
  • Maximum out-of-pocket spending: $6,350 for single coverage, $12,700 for family coverage

If you're unsure if your health plan qualifies as an HDHP, ask your human resources representative or call the insurance provider directly. Here's a tip: Some HDHPs go by the name consumer-directed health plans (CDHPs).

Next are the HSA contribution limits. The IRS puts a limit on how much money you can divert tax-free into an HSA annually. For the 2014 tax year, the contribution limit for self-coverage is $3,300 and up to $6,550 for family coverage. Folks over 55 can contribute an additional $1,000. Any money that you contribute in excess of those limits will be taxed as income plus a 6 percent excise tax if you don't spend it by April 15 of the following year [source: IRS].

Here comes the confusing part (this is the IRS, after all). You are considered eligible to invest in an HSA for the entire tax year even if you only become eligible on Dec. 1 of that year. So if you enroll in a qualifying HDHP in November 2014 and open an HSA on Dec. 1, you can contribute the full $3,300 or $6,500 tax-free for the 2014 tax year. This called the last month rule [source: IRS].

However, there's also something called a testing period. You must remain eligible for 12 consecutive months after you begin contributing to the HSA or any money you invested in the account will be taxed as income plus a 10 percent penalty [source: IRS]. Ways you could lose eligibility include switching to a low deductible health plan, enrolling in Medicare or qualifying as a dependent on someone else's tax return.

When tax day arrives, you will need to enter all HSA contributions on Form 8889. To help you out, the bank or other trustee managing your HSA account will mail you Form 5498 listing your total HSA contributions for the year. If your employer also made contributions, they will be listed in box 12 on your W-2 form.

On the next page, we'll explain how HSAs can double as retirement accounts.

HSAs can also be used to supplement retirement savings.
HSAs can also be used to supplement retirement savings.

A 65-year-old couple retiring in 2014 should expect to spend around $220,000 (in 2014 dollars) on out-of-pocket health care costs during retirement [source: Fidelity]. That's a serious chunk of change. Although health savings accounts are primarily marketed as tax-free ways to save money for ongoing medical expenses, they can also play a vital role in paying for expensive medical care during retirement. Especially if you've maxed out your yearly 401(k) contribution, this can be another way to squirrel away some pretax dollars.

If you start early and contribute the maximum amount to your HSA each year, you can put away $360,000 to $600,000 — depending on your rate of return on investments — to cover health care expenses during retirement [source: Carrns]. Amassing so much cash in your HSA requires making the maximum contribution for 40 years and never withdrawing a dime. That means you would need to make enough money during your working years to cover all out-of-pocket medical costs without tapping the HSA.



The same HSA rules apply for withdrawals after retirement. All HSA funds must be used to pay for qualified medical expenses. If you try to dip into the HSA account to pay for a golf outing in Hawaii, you will owe income tax on that cash, but not the 20 percent penalty. That's only for people 65 or younger [source: Carrns]. In that sense, withdrawing from an HSA after 65 is a lot like withdrawing from a traditional IRA, which is also taxed as income.

Don't forget the Medicare rule, though. Once you enroll in Medicare and start receiving Social Security benefits, you cannot make tax-free contributions to an HSA. You can, however, continue to withdraw money tax-free for qualified medical expenses, even when you are enrolled in Medicare.

To really make your money work for retirement, you will need to shift the majority of your HSA funds out of liquid money market-style accounts and into investments. Before you invest in mutual funds or other securities through your HSA, make sure to find out if the bank charges transaction fees for investments along with any ongoing maintenance fees for the account [source: Carrns]. These fees can really eat away at your savings. A website called HSASearch provides fee information on all U.S. HSA providers.

For lots more information on retirement planning and managing health care costs, check out the related HowStuffWorks articles on the next page.

Author's Note: How Health Savings Accounts Work

Writing about financial planning is not a natural fit for me — just ask my wife, the family budgetmaster — but I always learn a tremendous amount in the process. I admit that I really knew very little about health savings accounts before starting my research for this article, but now I'm convinced it's the perfect solution for us. As a freelance writer, I pay for my own health insurance coverage. To keep premiums affordable, we go with a high-deductible plan. Adding an HSA to our financial mix would provide a nice tax-free buffer for any unplanned trips to the emergency room. Maybe this newfound expertise will even raise my wife's opinion of my financial prowess. A man can dream, can't he?

Related Articles


  • Carrns, Anne. "Shopping for Investments in a Health Savings Account." The New York Times. Dec. 11, 2013 (Oct. 17, 2014)
  • Carrns, Anne. "Using Health Savings Accounts to Invest for Retirement." The New York Times. Aug. 19, 2014 (Oct. 17, 2014)
  • Federal Reserve Bank of St. Louis. "Personal Saving Rate" (Oct. 17, 2014)
  • Fidelity. "Retiree health costs hold steady." June 11, 2014 (Oct. 17, 2014)
  • Internal Revenue Service. "Publication 969" (Oct. 17, 2014)
  • Kaiser Family Foundation. "Employer-Sponsored Family Health Premiums Rose 3 Percent in 2014." Sept. 10, 2014 (Oct. 17, 2014)
  • Mann, Leslie. "What to know before investing in an HSA." The Chicago Tribune. Jan. 31, 2014 (Oct. 17, 2014)
  • National Business Group on Health. "U.S. Employers Changing Health Benefit Plans to Control Rising Costs, Comply with ACA, National Business Group on Health Survey Finds." Aug. 13, 2014 (Oct. 17, 2014)
  • Waldrop, Sharon Anne. "How to Get the Most Out of Your Health Savings Account." Forbes. Aug. 27, 2013 (Oct. 17, 2014)