In this week’s post, I explain the basics of a health savings account (HSA).
Health care costs can be astronomical. My favorite personal example of this is from back when I was in college – I was playing basketball and got elbowed in the face, creating a laceration near my eyebrow. Because it occurred at night, I was not able to go to an urgent care clinic, but rather went to an emergency room. Months later, when the bill arrived, I was shocked to learn that several stitches cost over $2,000.
Because health care can be so expensive, there are different tax incentives and account types that are designed to ease the burden. A health savings account (HSA) is one type of account that provides certain tax benefits when saving for health care expenses.
As we have continued to emphasize, remember that the type of investment account is distinct from the account’s investment holdings, as we covered in a previous post. The account has its own rules and tax treatment independent from the investments held within the account. This post will explore some of the account-level rules and tax treatment for a health savings account (HSA).
Who can contribute to a health savings account (HSA)?
As mentioned above, a health savings account is a special type of account that provides certain tax benefits when saving for health care expenses. However, funding a HSA is limited to individuals and families that that are covered by a high deductible health plan (HDHP). As in its name, a high deductible health plan (HDHP) is a health insurance policy that has a high deductible.
In order to be a high deductible health plan (HDHP) in 2022, an insurance policy needs a deductible of at least:
$1,400 for a policy covering an individual
$2,800 for a policy covering a family
There are maximums as well – we will discuss the different features and types of health insurance policies in a future post.
How much can be contributed and how are contributions taxed?
An individual can contribute to their own HSA. Employers can also make contributions to their employees' accounts.
The yearly contribution limits for a HSA vary depending on whether the underlying health insurance policy covers an individual or family:
The individual contribution limit is $3,650 in 2022
The family contribution limit is $7,300 in 2022
An additional contribution of $1,000 can be made by those that are age 55 or older.
These contribution limits aggregate between employee and employer contributions. For example, if an employer contributes $2,650 to their employee’s individual HSA, the employee can only contribute an additional $1,000 before reaching the yearly limit of $3,650.
From a tax standpoint, contributions made by individuals are adjustments to income or “above the line” deductions that will reduce income taxes. For more information about adjustments to income and how they differ from itemized deductions, see our post about income taxes. Contributions made by employers to their employees’ accounts are not included in the employees’ income. Whether being made by the individual or the employer, HSA contributions are made with pre-tax money.
Contributions can be made for a tax year until the tax filing deadline for that tax year. For example, tax year 2022 contributions can be made until the 2022 tax deadline in April 2023. Contributions and distributions must be reported on a special tax form.
Are investment earnings taxed?
Funds contributed to a health savings account (HSA) can be invested in different securities, such as mutual funds. If the contributions are going to be used quickly for immediate health care expenses, the funds can also just be left in cash.
Investment earnings in a HSA are not taxable, so the account grows tax-free.
When can withdrawals be taken and how are they taxed?
In order for a distribution from a HSA to be tax and penalty free, the distribution must be used for qualified medical expenses. The definition of “qualified medical expenses” is very broad and covers a variety of medical and dental expenses. However, there are certain exclusions, such as expenses for plastic surgery. For example, in the past I have personally used a HSA for doctors appointments, contact lenses, dental appointments, and a dental night guard.
HSAs cannot be used to pay health insurance premiums.
Example of a health savings account (HSA)
Reid has a high deductible health plan (HDHP). He contributed $500/year to his HSA and his employer contributed $1,000/year to his HSA for three years. Reid’s contributions were tax-deductible, and his employer’s contributions were excluded from income altogether. The account was left in cash, paying 1% interest per year.
At the end of three years, the value of the account is $4,545 ($4,500 of personal and employer contributions and $45 of interest). At the very end of the third year, Reid has a major surgery and has to pay his entire $5,000 deductible. The entire account can be withdrawn tax and penalty free to pay for this qualified medical expense.
Here is a visual:
If you have any comments, questions, or ideas for future posts, please let me know
I hope you found this post helpful and educational. If you have any comments, questions, or ideas for future posts, please let me know. You can reach me directly via email at crawford@ulmerfinancial.com.
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