In the post-election discussion about the future of U.S. health insurance, the role of health savings accounts has garnered increased attention. A health savings account (HSA) is a tax-exempt trust or custodial account available to people enrolled in a high deductible health plan. These specialized savings accounts are meant to provide funds for medical expenses that your health plan won't cover.
However, it's important to note that the law surrounding HSAs make them vastly different from standard savings accounts. Despite their similar names, health savings accounts come with a host of unique rules that determine when you can access your money and how taxes get involved when you do. In this way, HSAs have more in common with health and retirement funds than with other savings accounts.
Restricted Eligibility and Access
While just about anybody can walk into a bank or apply online for a regular savings account, there are specific rules that determine who can open a health savings account. The IRS defines an HSA-eligible individual as a person enrolled in a high deductible health plan (HDHP), with no other coverage under other plans and no enrollment in Medicare. For 2017, HDHPs are defined as plans with a minimum deductible of $1,300 for self-only HSAs and $2,600 for families.
There are also rules for adding to and taking funds from an HSA. The IRS imposes an annual HSA contribution limit of $3,400 for individuals and $6,750 for families. Until you retire, any distributions you request from your HSA for non-qualifying expenses will be considered part of your taxable income, and may also be subject to an additional 20% tax to boot. This makes other savings options more flexible than HSAs, both in depositing and withdrawing your money.
Three Distinct Tax Exemptions
However, HSAs offer multiple tax benefits that aren't available with a typical savings account. Funds you deposit into an HSA are tax-deductible, to an annual contribution limit of $3,400 for individuals in 2017. This provides HSA account-holders with a convenient way to reduce taxable income.
Second, money that you do withdraw for qualified medical costs is tax-free as well. As long as you adhere to the lengthy list of medical services determined by the IRS, you won't have to worry about paying income tax on your HSA distributions. And when you turn 65 or become eligible for Medicare, even your non-qualifying distributions —medical or otherwise —will come out tax-free too.
Finally, the money in an HSA is not taxed when it accumulates interest or gets invested in other financial products. The bank or credit union providing your HSA will offer different investment options where you can assign the funds in your HSA, but doing so means exposing that portion of your HSA balance to potential losses.
HSA Interest Rates and Deposit Insurance
Because they are less flexible than other savings accounts, HSAs on average earn higher interest rates on balances. Banks are naturally willing to pay better rates on deposits that are more likely to remain in place for the long term; this is the same reason regular savings accounts earn better interest rates than checking accounts.
Since they're often provided by the same banks and credit unions, both HSAs and savings accounts are covered by federal deposit insurance, which typically covers individuals to a total of $250,000. As stated above, however, any funds in an HSA which you choose to invest in other options provided by your bank won't qualify for this insurance.
Although HSAs offer several economic benefits not available to standard savings accounts, these benefits work best when you minimize the amount you withdraw from the account. Health savings accounts may provide a way for healthier individuals to reduce their tax exposure and grow their savings, but their usefulness can be limited if you have recurring medical costs to consider.