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How Does an HSA Work?

How Does an HSA Work? | Very Good Coverage

An HSA is a savings account that belongs to you and can help you pay for medical expenses tax-free. It’s like an extra emergency fund just for medical costs.

A Health Savings Account (HSA) can be vital in helping you save money for various out-of-pocket medical expenses. It’s a unique and special tax-advantaged savings account that allows you to keep more of your money tax-free to be specifically used now or in the future to cover certain health care costs. This article explains what HSA is, its eligibility, how it works, the medical expenses that it covers, and everything else that you need to know about HSA.

HSAs work with high deductible health plans. You can use your HSA account to save money before taxes and use the funds to cover qualified health care expenses. You can also use HSAs to save for retirement and can use the funds to pay for other living expenses without penalties.

The information used in piecing together this article is derived from IRS, Bank of America, Mayo Clinic, HSA Bank, and We’ve verified that the information is accurate and can help you decide whether or not HSA is right for you, how HSA works, and how to open HSA.

What is an HSA?

Health Savings Accounts (HSAs) are tax-advantaged medical savings accounts that are available to those who are enrolled in High Deductible Health Plans (HDHPs). Unlike the Health Reimbursement Arrangements (HRAs), which are company-owned, an HSA belongs to you and can be paired with HDHPs.

HSAs are also different from Flexible Spending Accounts (FSAs) in the sense that HSA funds can be rolled over and accumulate annually if not spent. This means that you can earn tax-free interest on the account. The funds can also be used to pay for qualified medical expenses at any time without being taxed.

In essence, an HSA account can help you cover your out-of-pocket costs if you have an HDHP insurance policy. It can also be an indirect investment strategy to save money that can help supplement your retirement plan.

Who is Eligible to Open an HSA?

The IRS has strict rules when it comes to determining who is eligible to own and contribute to an HSA. In other words, not everyone can open an HSA. Under the law, an eligible individual must meet the following guidelines:

  • You must be covered under a qualified HDHP either through the employer or on his/her own.
  • You must not be enrolled in Medicare
  • May not be claimed by a dependent of another individual’s tax return (unless it’s your spouse)
  • You must have a valid Social Security Number and be a primary residence in the U.S.
  • You must be covered by HSA-qualified HDHP on the first day of the month
  • You must not have received medical benefits from the Veterans Administration for non-service-connected disabilities in the last three months
  • You must not be covered by Tricare (the health care program of the US Department of Defense Military Health System)

And that’s not all. It’s also essential to understand what the IRS terms as qualified HDHP. To qualify for HSA, the HDHP must meet several requirements. It must have maximum yearly out-of-pocket limits for covered benefits. It must also have minimum deductibles and can cover certain preventive care services as well as other specific medical expenses.

Again, the plan cannot just cover a limited set of services such as coverage for a specific disease (for example dental-only coverage or cancer-only coverage). This law is in place to prevent individuals from opening and contributing to HSAs when the insurance they have only covers a narrow class of benefits.

The table below shows the deductibles and out-of-pocket requirements for an HSA-qualified HDHP for 2021.

The above amounts can be rounded to the nearest $50 annually to adjust for inflation. You should also keep in mind that a health plan is required to consider the usual, customary, and reasonable charges for the covered benefits. The deductibles must be met and premiums are not part of the deductibles.

In instances where a deductible requirement for prescription drugs is different from other requirements for other benefits, the HDHP will only be considered HSA-qualified when the prescription drug deductibles meet the same minimum requirements.

How Does an HSA Work?

Much like contributions to your employer’s 401(k) or your IRA, HSA is tax-free. This means that the money that you contribute to your HSA won’t be taxed. Here’s a perfect example. Let’s say that you make $60,000 in 2021 and decide to contribute $2,500 to your HSA, your taxable income will be $57,500.

HSA gives you the flexibility of contributing directly to the account through payroll deduction or by contributing after-tax dollars and then deducting that amount from your gross income on your tax return.

Some HSAs come with an HSA-attached debit card that you can use to withdraw the money from the ATM and reimburse yourself if you paid your medical expenses using another source of income. As a tax-free account, you aren’t required to pay income taxes on the money you withdraw from your HSA account through the ATM to cover the qualifying medical expenses or for reimbursing yourself from the account for covering the medical expenses.

The funds you have in HSA can grow tax-free and earn a small amount of interest just like it would in a normal savings account. The only major difference is that you can invest the money in your HSA account but you won’t be required to pay taxes on the gains as long as you do not remove the money from your HSA account.

And once you attain the age of 65, your HSA will somewhat function as a normal IRA account. This means that you will be able to withdraw and use the money freely not just in covering your medical costs like before but in your other day-to-day expenses. In other words, your HSA won’t just be limited to covering your medical expenses once you turn 65. Instead, it will be used to cover your medical costs and other expenses as well.

But there’s a caveat: you will have to pay income taxes on the amount you use on something other than qualified medical expenses. And even with that, the best part is that you won’t have to pay a penalty like you could have done if you used the money in the past for other expenses other than the qualified medical expenses.

Let’s emphasize this: Even though you can withdraw money from your HSA for non-medical expenses before you attain the age of 65, you’ll have to pay the normal income taxes plus a hefty 20% penalty. As such, it might not make much sense to pay such a hefty penalty for withdrawing from your HSA for non-medical expenses.

Which Medical Expenses are Considered HSA-Qualified?

There are several IRS-qualified medical expenses that can be covered by your HSA. In fact, most of them aren’t even covered by typical health insurance plans.

They include but are not limited to:

  • Acupuncture
  • Artificial teeth
  • Ambulance
  • Artificial limbs
  • Birth control treatment
  • Vasectomy
  • Vaccines
  • Annual physical exams
  • X-rays
  • Long-term care
  • Prescription medication

Here are the other most common medical expenses covered by HSA. Here’s is also a detailed breakdown of every qualified medical expense as outlined in the IRS website.

Medical Services that can be provided without Meeting the Deductibles

Normally, HSA-qualified HDHPs shouldn’t provide any form of benefit before the deductibles have been met. However, the rules have changed and some services can be provided even if you’ve not met the deductible threshold. Let’s note some of them.

Preventive Care

This generally revolves around specified items and services that are deemed by the government to help in treating an individual with certain chronic conditions. The main aim is to ensure that the chronic condition doesn’t get out of hand or even develop into a secondary condition.

The table below shows HSA-qualified HDHP preventive care services that can be provided even if the deductibles haven’t been met.

Allowable Telehealth Services

HSA-qualified HDHPs are allowed to provide Telehealth and other remote care benefits even if the deductibles haven’t been met. This provision was included in the CARES Act with the main aim of increasing health care access for any individual who qualifies for HSA-qualified HDHP and may have COVID-19.

Needless to say, this is to help in protecting other patients from potential exposure. Under such circumstances, you won’t lose your HSA eligibility by failing to meet your deductibles.

HSA ContributionLimits in Recent Years

Unlike the traditional savings accounts where you can save whatever amount that you have, your contribution to an HSA is limited each year. You can contribute up to $3,600 in 2021 for an individual plan (self-only coverage) or up to $7,200 for family coverage.

Again, there’s what’s known as a “catch up” contribution, which is meant for those aged 55 and above and want to contribute to HSA. This gives you the chance of contributing an extra $1,000 but the limit might be reduced by the amount of contribution that your employer makes to HSA and is excluded from your income.

The table below highlights the HSA contribution limits in the last five years.

HSA Minimum Deductibles

Although certain services and benefits may be provided even if you do not meet the minimum deductibles, it’s an important requirement. For 2021, the minimum deductibles are $1,400 for individual coverage and $2,800 for family coverage.

The following table shows HSA minimum deductibles in the last few years.

HSA Maximum Out-of-Pocket Limits

An HSA-qualified HDHP must also have maximum out-of-pocket limits. These are the limits that you have to pay and include your deductibles, copayment, and other out-of-pocket costs. As we noted earlier, the out-of-pocket limits for 2021 are $7,000 for individual coverage and $14,000 for family coverage.

Below is a look at the HSA maximum out-of-pocket limits in the last few years.

Who Can Contribute to Your HSA?

While eligible individuals can make direct contributions to the HSAs, anyone including your family member, employer, or any other person can make contributions on your behalf. The state government can also make HSA contributions on your behalf if you’re insured under state high-risk pools that qualify as HDHPs.

In short, anyone can make contributions to your HSA as long as the total amount of contribution doesn’t exceed the yearly contribution limits. The best part is that the contributors cannot limit, restrict, or dictate how HSA funds are used.

If you’re employed, you can choose to make your HSA contributions through what’s known as cafeteria plans. These are benefits arrangements that are created by employers so that you (and other employees) accept lower take-home pay so that the difference is deposited in their HSAs.

Opening an HSA

You can open your HSA throughout the year as long as you are enrolled in an HSA-qualified HDHP. In other words, you do not have to wait for the open enrollment period to open an HSA. Normally, many people will enroll for HSA through their employer’s website or even online.

If you’re opening the account independent of your employer, you should consider using the HSA-provider’s website to make the online enrollment process easier. You can also choose to enroll in person or online if you are opening an HSA account at a regular bank.

Withdrawing from an HSA Account

HSA withdrawals are exempt from income taxes if used to cover qualified medical expenses for you, your spouse, or your dependents. There’s no limit on when or how much withdrawal can be made.

You should, however, keep in mind that you’ll be subjected to a 20% penalty if you withdraw for non-medical expenses. The penalty may be waived if you are aged 65 and in case of disability or death.

That being said, here’s a look at the HSA penalty taxes.

You should keep in mind that you’ll be deemed eligible for the year if you were eligible for the last month of the year. This means that you’ll be allowed to contribute up to the annual limit. You’ll, however, have to maintain your HSA eligibility for the following year, which is known as the testing period.

Benefits of HSA

An HSA account offers several benefits including:

The Money is Yours

The money that you or anybody else contributes to your HSA remains yours even if you leave your job, leave your health plan, or retire. As such, you can use your HSA as an extra saving or investment account for retirement.

You Realize Tax-free Savings

An HSA provides triple-tax savings in the following ways:

  • Your contribution to the HSA is tax-free whether it comes from you, your employer, your friends, or relatives
  • You can withdraw your money from HSA tax-free as long as you use it for qualified medical expenses
  • Your account and investment earnings can grow tax-free as long as they remain in the account

You can Grow Your Account

You have the right to decide whether to spend your HSA money to cover your qualified health expenses or to save it. The balance can roll from year to year and can gain interest. If your balance is large enough, you can choose to invest it tax-free as long as the money remains in the account.

It Gives You More Choices and Flexibility

An HSA gives you a wider choice and flexibility in managing your healthcare options. It also makes it possible to afford the high out-of-pocket costs. That’s not all; an HSA makes it a lot easier to manage healthcare costs since it gives you more responsibility over your healthcare decisions and choices.

When You Should or Shouldn’t Use an HSA?

Here are a few scenarios that make HSA ideal for you.

Your employer offers HDHP – If your employer offers HDHP, you may have to open an HSA to help you deal with high deductibles. You also do not want to miss out on HSA contributions made by your employer.

Want a plan to cover your medical expenses now and in the future – An HSA account can be ideal if you want to cover the huge out-of-pocket costs now and in the future.

Interested in tax-free incentives – HSAs are tax-free and can be ideal if you want to lower your taxable income.

Require an extra emergency fund for your medical expenses – This can be a perfect solution for the rainy days as far as medical expenses are concerned.

Disciplined enough to put money aside – An HSA can be ideal if you’re a good saver.

In good health and rarely go to the doctor – If you’re in good health and only looking to pay low monthly premiums, an HSA can be ideal in helping you cover the high deductible costs that come with low monthly premiums.

On the other hand, an HSA may not be ideal for you if:

Have an ongoing medical issue – If you anticipate having lots of medical expenses, HDHPs have high deductibles and may not be ideal for your situation.

Want to build savings – An HSA may not be a priority if you do not have savings for rainy days.

Live check to check – If you are low on income and have an extremely tight budget to contribute to HSA.


Greg McKnight

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