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Health savings accounts: Everything you need to know

At a glance:

  • What are HSAs? Here are the basics

  • How Health Savings Accounts work

  • Advantages and disadvantages of health savings accounts

  • Qualified medical expenses for Health Savings Accounts

  • Paying for a family member's medical expenses from a Health Savings Account

  • Tax and audit issues of Health Savings Accounts

  • Tax-free expenditures from Health Savings Accounts

  • Non-tax-free expenditures from Health Savings Accounts

  • Summary of Health Savings Accounts

  • Practical ideas you can start with today

Increasingly, employers are asking their employees to enroll in health insurance policies with higher deductibles than traditional policies, either as an option or the only health insurance plan available to employees.

Sometimes, individuals and families purchasing health insurance on their own can only find affordable health insurance if they choose a policy with a high deductible.

Some, but not all, of the newer health insurance policies with high deductibles may qualify you for a relatively new type of financial account called a "health savings account" or "HSA."

An HSA offers a way to put aside money to pay for routine medical expenses and help you save money on taxes. HSAs are designed to fill in the gaps for insurance policies that cover larger medical bills.

Don Humbertson, a 64 year old lung cancer survivor, is examined by Dr. Wade Harvey in Blacksville, West Virginia. (Photo: BRENDAN SMIALOWSKI/AFP via Getty Images)
Don Humbertson, a 64 year old lung cancer survivor, is examined by Dr. Wade Harvey in Blacksville, West Virginia. (Photo: BRENDAN SMIALOWSKI/AFP via Getty Images)

What are HSAs? Here are the basics

Health savings accounts (HSAs) were created by federal legislation enacted in 2003. HSAs are now available to any individual or family with HSA-qualified insurance (i.e., high-deductible health plan).

There are no limitations on who may have an HSA based on income or employment status.

However, dependent children cannot have their own HSA accounts but may be covered by the HSAs of their parents.

Saving money for your deductible

Most of us know that we can lower our premiums on our auto or homeowners insurance by raising our policy deductible. But few of us actually put the savings into a "rainy day" fund in case we actually have to pay our deductible when we have a claim.

HSAs offer a way of putting money into that "rainy day" fund for healthcare. The tax benefits that come with the HSA make the opportunity that much better.

Health savings accounts do not solve all of the problems with obtaining health insurance. However, for many individuals and families, HSAs can make health insurance more affordable while providing an alternative way of financing their medical coverage.

How Health Savings Accounts work

HSA-qualified insurance works very similar to traditional insurance.

Some medical providers prefer to submit a claim for the services provided to the insurance company first and bill you after the insurance company applies their discount and your policy deductible.

This ensures that your claim is for a covered service, that you get the benefit of the insurance company’s negotiated fee with the provider, and that your expenses are counted towards satisfying your policy deductible.

Your insurance company will then likely send you an "explanation of benefits" (EOB) showing the services provided, the charges submitted, and discount(s) applied. The EOB will also let you know how much you owe the medical provider.

Billing

The medical provider will likely send you a bill for the amount you owe. If you have a debit card or checks to access your HSA account funds, you could use either form of payment the provider is willing to accept. You could also pay the provider in cash (or personal check or credit card) and reimburse yourself from your HSA account later.

You can wait to reimburse yourself from your HSA account for many years into the future. There is no time limit on when you must use your HSA funds. However, if your receipts are no longer legible, you may have no proof that you incurred qualified expenses.

Medical bills are spread out on the kitchen table of a cancer patient in Salem, Va. (Photo: AP Photo/Don Petersen, File)
Medical bills are spread out on the kitchen table of a cancer patient in Salem, Va. (Photo: AP Photo/Don Petersen, File)

You can pay for expenses with checks or debit cards

Many banks and credit unions offer checks or debit cards that you may use to pay for expenses at the time the services are provided. These features offer easy access to your account funds, including reimbursing yourself for expenses you have already incurred.

Be aware that some of these features have associated fees, especially when using a debit card to withdraw "cash" from your HSA account, even if you are reimbursing yourself for a qualified medical expense.

When expenses are actually incurred

An expense is incurred when you pay for the services or treatment, not the date on which the services or treatment were provided. For example, if you see your doctor on April 2 and pay a co-pay at the end of your office visit, the amount you pay would be an expense incurred on April 2.

If the doctor conducts some blood tests during your April 2 office visit and bills you for the tests, the date you incur an expense is the date you pay this bill (e.g., June 12).

Buyer's guide

When you go to your medical provider, you should let them know that you have an insurance policy with a high deductible and that you may end up paying the entire amount for the services provided.

You may want to offer to pay something before you leave the provider's office, as you would do when you have to pay a co-pay under a traditional policy. Some medical providers are concerned that they will have a harder time collecting from you if you don't pay something before you leave.

These concerns may make your medical providers less willing to accept your HSA-qualified insurance in the future.

Chris Rogers, right, talks to Epilepsy Foundation Navigator Barbara Meneses as Rogers prepares to enroll for health care coverage. (Photo: AP Photo/Alan Diaz)
Chris Rogers, right, talks to Epilepsy Foundation Navigator Barbara Meneses as Rogers prepares to enroll for health care coverage. (Photo: AP Photo/Alan Diaz)

If you incur medical expenses early in the year, you may not have enough funds in your account to pay or reimburse yourself for the expenses you incur.

If you will not be making the maximum contribution to your account through your employer and/or by payroll deduction, you could deposit the remaining funds you are allowed to contribute into your account at any time.

If you can work out a payment plan with the provider, this may give you more time to deposit funds into your account.

Your employer may also be willing to loan you the money which you could pay back over time (Note: employers are not required to do this.) Over time, this may not be as much of a problem if you have unused funds that roll over to the next year.

Advantages and disadvantages of health savings accounts

Health savings accounts come with several advantages.

Security

HSA-qualified insurance and the HSA account provide protection against high or unexpected medical bills. You also will receive the benefit of the lower fees negotiated between your insurance carrier and your health care providers, instead of paying the full charges. All policies also cover preventive care services to help you maintain your health and avoid illness and disease.

Affordability

HSA-qualified insurance makes health insurance more affordable with premiums. The savings can be substantial, which can help you fund your HSA account.

Flexibility

HSA funds can pay for current medical expenses, including expenses that insurance may not cover. Funds can also be saved for future needs, such as:

  • Health insurance premiums or medical expenses if no longer working (such as COBRA or when unemployed or retired but not yet on Medicare)

  • Out-of-pocket expenses and premiums (except for Medigap premiums) when covered by Medicare

  • Long-term care expenses and insurance

Control

You make all the decisions about your HSA account. You can make choices that are best for you, and physicians can be more effective patient advocates, with less intrusion from insurance companies.

Portability

HSA accounts are completely portable. You can keep and take your account with you even if you:

  • Change jobs or become unemployed

  • Change your medical coverage or marital status

  • Move to another state

Ownership

You own the funds in your account. The funds in the account remain and roll over from year to year, just like an IRA. There are no "use it or lose it" rules for HSAs.

Tax savings

HSAs provide three tax savings benefits:

  • tax deductions when you contribute

  • tax-free earnings through investment

  • tax-free withdrawals for certain qualified medical expenses (withdrawals for non-qualified expenses will be taxed and penalized)

Disadvantages of HSAs

Health savings accounts have some disadvantages.

Change

You must switch to HSA-qualified insurance from traditional insurance. Sometimes this means you must change insurance carriers as well.

Insecurity

Switching from traditional first-dollar coverage makes many people uncomfortable. HSA-qualified plans are relatively new to many people, and they have high deductibles.

Other coverage

You may be ineligible to contribute to an HSA if you or a family member has other insurance coverage that is not HSA-qualified, or has a flexible spending account or health reimbursement account through their employment.

Control

Some people prefer to have a third party (e.g., employer, insurance company) manage their health coverage for them. Employers and insurance companies are able to negotiate discounts for services and help us navigate the health care system in unique ways.

Emergencies

When you have an urgent situation or emergency, it is inconvenient and sometimes impractical to consider "comparison shopping." Thankfully, most health care is provided in non-emergency situations.

Information

Sometimes it is difficult to get good information on health care prices and quality of services so you can comparison shop for good value in health care. Fortunately, better information is becoming available every day.

Tax filing

You must file an income tax return to take advantage of all the benefits HSAs offer. Lower-income individuals and families may not realize all the savings of HSAs if they pay no income taxes. However, they can still save on FICA taxes and other taxes by paying for out-of-pocket expenses with funds from their HSA.

Qualified medical expenses for Health Savings Accounts

The types of expenses that qualify for reimbursement from an HSA include more than just what your insurance covers.

In fact, HSA funds can be used to cover many items and services that insurance often does not cover, including over-the-counter medications, vision care expenses (including laser eye surgery), dental care expenses (including orthodontia), chiropractic care, and much more.

Although over-the-counter medicines are considered a qualified medical expense, due to the enactment of health reform legislation HSA account holders are now required to have a prescription from their doctor for the over-the-counter medicine to be reimbursed or paid tax-free with HSA funds. (The only exception to this is for insulin.)

Over-the-counter medicines are considered a qualified medical expense. (Photo: AP Photo/Ebrahim Noroozi, File)
Over-the-counter medicines are considered a qualified medical expense. (Photo: AP Photo/Ebrahim Noroozi, File)

Using funds for other purposes

In most instances, you may not pay for health insurance premiums with HSA funds. However, the funds can help you pay for your health insurance premiums during periods when you are between jobs.

For example, you can use your funds to pay premiums for COBRA continuation coverage from a former employer.

You can also use your funds to pay health insurance premiums if you are receiving federal or state unemployment compensation. In either case (COBRA or unemployment), you can pay premiums for health insurance even if it is not HSA-qualified insurance.

HSA funds can be saved for certain longer-term expenses

Looking towards retirement, HSA funds can be saved and used to pay for long-term care insurance and expenses, Medicare out-of-pocket expenses (deductibles, co-pays, and coinsurance) and monthly premiums for Part A (inpatient hospital), Part B (physician and outpatient), Part D (prescription drugs), and Medicare Advantage plans.

The only thing for which HSA funds may not be used tax-free is premiums for Medicare Supplement (i.e., Medigap) insurance.

Buyer's Guide

You have great flexibility when determining how to use your account funds. This is one of the great advantages that HSAs offer.

You alone determine whether to use your account to pay for current medical expenses or save the funds in your account to pay for expenses in retirement. However, be aware of fees associated with different ways of accessing your account funds.

Paying for a family member's medical expenses from a Health Savings Account

Your HSA account funds can be used to pay for not only your qualified medical expenses, but also the qualified expenses incurred by your spouse and dependents.

Your spouse and dependents do not need to be covered by your HSA-qualified plan.

Rules for spouses, dependents, and relatives

Your HSA-qualified policy should specify who is considered a "spouse" or "dependent" for purposes of your insurance coverage. In many cases, domestic partners are considered part of the "family" for policies providing family coverage.

However, the rules for using your HSA funds are more rigid and specific:

  • You and your spouse must be legally married under state law. This now includes same-sex couples who were married in a state or foreign country that has the legal authority to sanction same-sex marriages. However, it does not include same-sex or opposite-sex domestic partners who are not legally married.

  • "Dependents" generally must be either:

    • a child (son, daughter, stepchild, etc.) who lives with you more than half of the year and who is 18 years or younger for the entire calendar year (or under age 24 and a student for the entire year) or is permanently and totally disabled, or

    • a "qualifying relative" who lives at the same principal place of residence as you for the entire year and receives at least half of his/her financial support from you. In addition, the relationship between you and the qualifying relative cannot be in violation of local law.

    If a domestic partner meets the definition of a qualifying relative

    This means that your HSA funds may not be used tax-free for qualified medical expenses incurred by a domestic partner unless the domestic partner meets the definition of a "qualifying relative."

    If the domestic partner is not a "qualifying relative," you must pay income taxes on the amount of your HSA that you use to pay for his or her medical expenses plus an additional 10% tax penalty.

    However, remember that domestic partners may also be eligible to establish their own HSA and make tax-deductible contributions to it.

    Tax and audit issues of Health Savings Accounts

    Your account custodian/trustee and your employer do not have any responsibility to review or approve the expenses for which you use your account funds. If your tax return is audited by the IRS, you will need to prove that your medical expenses were "qualified."

    You will have to pay income taxes and a tax penalty (20%) on the amount that was not "qualified." Once you reach age 65 (or become disabled), you no longer have to pay the 20% penalty, just income taxes on amounts used for non-qualified expenses.

    Tax forms to know about

    After the end of the year, you will be sent tax forms that indicate how much you contributed to your HSA account for the calendar year, how much you withdrew from the account during the year, and your ending balance on December 31.

    You do not need to itemize your deductions to take the deduction on your income taxes for the amount you contributed for the year. You will need to file a tax form (Form 8889) with your tax return which documents your HSA account funds and tax deductions.

    Keep good records

    Keep track of all your EOBs and receipts. This is the only proof you have that your expenses were "qualified medical expenses."

    You are responsible for using your account funds appropriately so you need to keep good records to indicate that you used your HSA account funds exclusively to pay for or reimburse qualified medical expenses.

    These medical expenses may not be paid by insurance and may not be claimed as a "medical expense" if you itemize your deductions in the same year.

    Tax-free expenditures from Health Savings Accounts

    This list is illustrative and is not meant to be exhaustive. There have been thousands of cases involving the many nuances of what constitutes "medical care" under the Internal Revenue Code, which governs health savings accounts.

    A determination of whether an expense is qualified as "medical care" is based on all the relevant facts and circumstances. To be an expense for medical care, the expense has to be primarily for the diagnosis, cure, mitigation, treatment, or prevention or alleviation of a physical or mental defect or illness.

    The determination often hangs on the word "primarily." Additional information is available from IRS Publication 502. Consult your physician and tax advisor if you have questions.

    • This list is not exhaustive. See IRS Publication 502 for more information.

    • Acupuncture

    • Ambulance services

    • Artificial limbs and teeth

    • Bandages

    • Birth control pills (by prescription only)

    • Breast reconstruction surgery (mastectomy)

    • Childbirth, labor and delivery services

    • Chiropractic services

    • Christian Science Practitioner services

    • Contact lenses

    • Cosmetic surgery, but only if due to trauma or disease

    • Crutches

    • Dental care

    • Diagnostic devices

    • Drug addiction treatment (inpatient)

    • Eyeglasses

    • Fertility treatments

    • Gynecology services

    • Hearing aids

    • Home care

    • Hospice care

    • Hospital services (inpatient and outpatient)

    • Laboratory services

    • Laser eye surgery (e.g., LASIK)

    • Long-term care (does not include custodial care)

    • Maternity care

    • Medicare deductibles, copays, coinsurance, premiums

    • Nursing services

    • Nursing home care

    • Ophthalmology services

    • Organ transplants (including donor's expenses)

    • Orthodontia

    • Orthopedic services, including orthopedic shoes

    • Osteopathic services

    • Over-the-counter medicines (prescription from a licensed medical professional required)

    • Oxygen and equipment

    • Pediatric services

    • Personal care services for chronically ill persons

    • Podiatry services

    • Pre-natal and post-natal care

    • Prescription medicines

    • Prosthetics

    • PSA tests

    • Psychiatric care

    • Psychology services

    • Radiology services

    • Smoking cessation programs

    • Splints

    • Surgical services

    • Transportation expenses for health care

    • Vaccines

    • Vision services

    • Vitamins (only if prescribed by a licensed practitioner)

    • Wheelchairs

    • X-rays

    Non-tax-free expenditures from Health Savings Accounts

    • Advance payment for future medical expenses

    • Athletic club membership

    • Automobile insurance premiums

    • Babysitting (for healthy children)

    • Boarding school fees

    • Bottled water

    • Cosmetics and personal hygiene products

    • Dancing lessons

    • Diaper service

    • Domestic help

    • Electrolysis or hair removal

    • Funeral expenses

    • Hair transplants

    • Health programs at resorts, health clubs, and gyms

    • Household help

    • Illegal operations and treatments

    • Illegally procured drugs

    • Maternity clothes

    • Nutritional supplements

    • Premiums for life, disability, other accident insurance

    • Scientology counseling

    • Social activities

    • Special foods/beverages

    • Swimming lessons

    • Teeth whitening

    • Travel for general health improvement

    Summary of health savings accounts

    HSAs are becoming a valuable new health care program for many people.

    Part of the idea behind them is to put more control over health care spending decisions into your hands while keeping some of the money you used to pay to the insurance company. This puts you and your doctor in charge of how your money is spent without interference from your employer or your insurance carrier.

    Though they are fairly new, HSAs are believed by many to be one of the long-term approaches to making health care more affordable for the future.

    Research your covered expenses thoroughly. If you are not careful, you may find yourself having to explain yourself to the IRS and, worse, having to pay taxes and/or penalties as well.

    What is qualified and is not qualified is not always crystal clear, which is why there have been so many IRS cases involving medical care. The information in this post will serve as a good starting point for more comprehensive research.

    For more information, consult IRS Publication 502.

    Practical ideas you can start with today

    • Determine how you will access your health savings account funds—with a debit card, checking account, or other means. Ask your HSA provider about options.

    • Familiarize yourself with the list of allowable and non-allowable expenses in IRS Publication 502. Bookmark the link for it.

    • Estimate your covered healthcare expenses for the year and plan to match them with contributions.

    • Keep all records and receipts for allowable expenses in one location.

    This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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