How Health Savings Accounts Work

The Benefits of Health Savings Accounts

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.