Health savings accounts (HSAs) are used in conjunction with high deductible health plans and offer five tax advantages compared to traditional savings accounts:
- Your own contributions to the HSA are tax-deductible in the current year.
- Employer contributions to the HSA are excluded from income.
- Earnings inside the HSA (i.e. interest, dividends, and capital gains) are not subject to federal tax.
- Distributions from HSAs that are used to cover eligible medical, dental, and other healthcare expenses are tax-free.
- There are no carryover restrictions, meaning any amount you contribute to a HSA and do not use in the current year can stay inside the plan and continue to accrue earnings until it is needed.
Eligible healthcare expenses include prescription medications, prescription eyeglasses, and fees paid to health care providers (co-pays) or hospitals, to name a few. Any amount of a distribution from a HSA that is not spent on qualifying medical expenses is taxable. You can also use a HSA to pay for long-term care insurance or to cover health insurance premiums if you are unemployed.
Despite the many advantages of HSAs, there is one significant drawback: you must be enrolled in a high-deductible health insurance plan to qualify to use a HSA. These plans generally require you to commit to large out-of-pocket medical expenses and are not for everyone.