Health Savings Account vs. Flexible Spending Account

“I might have an eye procedure done towards the end of the year, depends on how much is left in my Flexible Spending Account” – Friend

“Do you have access to an HSA instead”? – Me

“What is an HSA?” - Friend

Flexible Spending Account, or FSAs, became popular in the 1980s. They were created as a tax friendly way to save for medical expenses and dependent (child) care expenses not covered by an employer-sponsored health care plan.

There are two potential drawbacks to an FSA:

1.     You have to decide at the beginning of the year how much you want to add to your FSA through payroll deductions

2.     Use it or lose it – either spend it by the end of the year or lose the money (there could be a ~$500 roll-over allowed if the Employer opts in… but its pretty much use it or lose it)

The primary benefit is using pre-tax money, so your money goes a little farther in paying for the out-of-pocket medical costs and dependent care.

 So why did I immediately ask my friend if she had an HSA option?

Health Savings Accounts, HSAs, are triple tax-advantaged and the money rolls over each year automatically, no use it or lose it.

To qualify for an HSA, you must be covered by a High Deductible Health Care Plan, you can’t be on Medicare, and you can’t be claimed as a dependent on someone else’s tax return. IRS Publication 969 covers the fine print for eligibility.

If the annual deductible at least $1,500 (Individual coverage) or $3,000 (Family coverage) and the out-of-pocket max doesn’t exceed $7,500 (Individual) and $15,000 (Family), then you are covered by a High Deductible Health Care Plan.

Assuming you qualify, you can open a Health Savings Account at a number of places: Fidelity, HSA Bank, Optum, UMB. I use Fidelity because they don’t charge fees and it’s easy to invest the funds to earn extra interest.

Money going into the HSA is tax deductible. Your employer may allow you to set up payroll deductions to fund your HSA, or you can deposit money into your HSA without the employer being involved. Either way, you can take a deduction on your tax return for the HSA contributions.  

The maximum (2023) annual contributions are $3,850 (Individual) and $7,750 (Family), and there is a $1,000 catch up if you are age 55 or older.

 You choose when to seek reimbursement from your HSA. As long as the funds are used for qualified medical expenses, the funds come out tax free. The HSA is owned by you even if you change jobs or don’t spend the funds each year.

Lean in... this is what makes an HSA really special: you can keep records of your qualified medical expenses but not take a distribution from your HSA. You can choose to invest the money in the HSA. Any interest, dividends, or appreciation from the investments can also be withdrawn tax free (sometimes decades later) as long as you have the medical receipts to prove qualified medical expenses were incurred. The CPA nerd in me calls this the Tax Unicorn. I can take pre-tax money, invest it, and as long as I have medical receipts, all the money including earnings is tax free. Wowza – that’s a good deal!!

 Are there any pitfalls?

Picking the right health care plan depends on your individual medical needs. High deductible plans make the most sense for people that are relatively healthy and have minimal health care cost. There may be a situation where the high deductible plan will cost you far more money in out-of-pocket expense and the tax advantages don’t make sense. The HSA will not make sense for everyone.

If you are age 64 or younger, and you withdraw funds for a non-qualified medical expense (like to pay for a vacation), then you will owe a 20% penalty and income taxes.

 Final Thoughts

If you qualify for an HSA, think about the pros and cons of the account. A health care nest egg may give you some additional peace of mind if you have unexpected health care expenses. Any money you don’t use will continue to accumulate tax-free over time.

You may also be able to have the best of both worlds - you could use a workplace FSA for qualified dependent care expenses and use the HSA for the qualified medical expenses.

If you are unsure about investing your HSA or unsure if an HSA is right for you, Look Both Ways Financial can help you with a one-on-one conversation.

Look Both Ways Financial is dedicated to personal finance education. While Kaki Perdue is a CPA, Look Both Ways Financial is not a CPA firm.