Health Savings Accounts: HSA pros, cons, and limits

When signing up for benefits at a new employer or during a health plan or open enrollment period at your workplace, you'll learn about insurance plans, retirement savings accounts, and other employee benefits you're eligible for.

Human resource representatives describe different health care plans, monthly premiums, deductibles, and copays, and coworkers may converse about their experience with various benefits. But one program you'd like to learn more about is a health savings account or HSA.

A health savings account allows you to save for the cost of medical care while reducing your taxable income.

You need to know some rules about who's eligible for an HSA, how it works, the amount of money you can contribute to it, and some pros and cons of using them, so let's dive in.

What Is a Health Savings Account (HSA)?

In the simplest terms, a health savings account is a tax-advantaged savings account for medical expenses. This means you can use the tax-free money you put into the plan and any interest or growth it accumulates to pay for eligible health care costs.

One nice feature of an HSA, besides the tax savings, is that you may also be able to use it as an investment vehicle for the future.

The money in the HSA is not taxed when it's contributed, similar to a traditional 401k payroll deduction. This reduces your taxable income for the year and means you keep more of your hard-earned money.

Note: An HSA is different from a Medical Flexible Spending Account (FSA) or a Health Reimbursement Arrangement (HRA). You can learn more about these types of accounts and understand their key differences in our article on Medical Savings Accounts.

One advantage of an HSA vs. FSA is that you don't need to spend the money on qualified health care expenses within a specific timeframe. The unused money in an HSA rolls over from year to year.

There are maximum annual amounts you can contribute to an HSA, however.

The annual contribution limit for HSAs in 2022 is $3,650 (2021 – $3,600) for an individual and $7,300 (2021 – $7,200) for a family. Adults over 55 can contribute an additional $1,000 over the annual limit.

Who is Eligible for an HSA?

Per the Internal Revenue Service, anyone who meets the following criteria is eligible for an HSA:

• Must choose a Qualified High Deductible Health Plan (HDHP) for your medical insurance and be covered on the 1st of the month for the month they are contributing to an HSA.*
  The IRS defines an HDHP for an individual as a plan with out-of-pocket expenses at a maximum of $7,050 and a minimum deductible of $1,400. For a family coverage plan in 20212, the out-of-pocket maximum is $14,100, and the minimum deductible is $2,800.
• Not covered by any other medical insurance policy, such as a spouse’s health insurance plan
• Not enrolled in Medicare
• Must not be claimed as a dependent on someone else’s tax return

*You can only contribute pre-tax money to an HSA for the months that an HDHP covers you. So if you changed jobs and were only covered by an HDHP for 6 months of the calendar year, you can only contribute for those 6 months. For a family HSA that would mean you could contribute $3,650 for the year.

Talk to the benefits director at your employer to see if they offer this type of account in your benefits package.

And don't worry about if you were to leave your employer once you've started contributing to an HSA because you can roll it over like a 401(k) or 403(b) to another HSA account.

If not offered through your employer, check with your financial institution to see if they offer an HSA.

If your bank, credit union, or brokerage offers an HSA as an option, the difference will be that money will go in post-tax, but you'll document and adjust for the tax deduction when you file income taxes at the end of the year.

Morningstar released its 2021 Rankings of Top HSA Providers to identify which HSAs represent the best choices for individuals instead of employers, where fees are often negotiable based on several factors.

What are the Pros of an HSA?

1. Pre-tax Benefits
One of the most significant benefits of an HSA is you contribute the money on a pre-tax basis. You're thereby reducing the amount of income and Social Security tax you'll pay for the year.

For example, say you make $50,000 per year. If you put $5,000 in your HSA, you will be taxed as if you earned $45,000, which lowers your taxable income.

2. Boost Retirement
Additionally, you can use an HSA to boost your retirement if any funds remain in the account. An HSA can be cashed out at age 65 but doesn’t have to be. There's no mandated payout at age 72 ½ that is typical of traditional retirement plans.

3. Employer Contributions
Companies may contribute to their employees’ HSA accounts. All contribution amounts are determined by each employer, with a typical range of contributions anywhere from $500-$2,000. This may be a smaller amount than a standard 401K plan, but it's still free money.

4. Growth
If you don’t use your HSA fund, it accumulates tax-free interest. It's like having a “medical” emergency fund account for what is often people’s most significant expense.

Many HSA’s are like a 401K in that you can choose how your plan is invested. The option to invest in a mutual fund or another investment product depends on which HSA company your employer (or financial institution) utilizes.

People maxing out their 401K’s can use an HSA as another way to save additional tax-free money.

5. Choices
The HSA gives you the freedom to access your pre-tax dollars for qualified expenses you incur for medical care.

The money in your HSA can be used for various types of health care expenses, including prescription drugs, over-the-counter medications, dental expenses, glasses, vision care costs, and more.

You can also use it at quick care providers, which are increasing in popularity because of the convenience and cost benefits.

What are the Disadvantages of an HSA?

1. High Deductible Plan
Having a high deductible plan means a lower monthly premium, but you will pay more out-of-pocket medical expenses before your health coverage kicks in.

Your upfront costs will be higher than traditional health plans, whenever you have to use your medical coverage during the year until you meet the deductible.

2. Account Contribution Limits
There are limitations to how much you can add to your HSA each year. For 2022, the maximum contribution limit for those under eligible family plans is $7,300. For those with self-only coverage, the contribution maximum is $3,650.

(Anyone 55 years or older qualifies for catch-up contributions and can put an additional $1,000 into their account annually.)

3. Penalties and/or Fees
If an HSA is not used correctly for eligible medical expenses, a tax penalty of 20% will apply. It’s also essential to watch out for HSA companies that may have account maintenance fees.

4. Risks
Since an HSA is similar to a 401K, there are typical risks associated with it regarding investing. The money is invested in the market, and a decline in the market could also cause account values to see a drop.

How To Use an HSA

An HSA is easy to use for healthcare expenses. Most employers give you a card, like a debit card, to use when paying for all eligible medical expenses that you'll swipe like a credit card. Some companies also provide checks connected to your HSA balance.

If you pay for an eligible dental or vision expense, or any medical cost out of pocket with a personal check or credit card, you can file a claim for reimbursement. How an HSA is used precisely is dependent on your benefit plan and company guidelines.

Funds not used on out-of-pocket healthcare expenses will remain in the account and any growth on the unspent money will be tax-free if later used to pay for eligible health care expenses.

Any unused funds left in your HSA when you reach age 65 can be withdrawn without penalty for any purpose besides just eligible expenses for healthcare. You will pay federal income tax on the amount withdrawn when used for non-medical expenses, though.

Is setting up an HSA worth it?

Determining if an HSA is right for you requires comparing traditional health plans with HDHP coverage plus an HSA.

You'll want to review insurance company plan documents, the health insurance premiums, deductibles, and out-of-pocket limits, and then decide which is the most cost-effective option for your family situation.

There are pros and cons associated with an HSA, and there are limits to how much you can contribute each year.

Still, it's an appealing option for those who meet eligibility requirements and seek another tax-advantaged investment option in addition to the traditional 401K.

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Article written by:

Misty, a Women Who Money contributor and the creator of Home Money Habits. She's a mom on a mission to simplify & organize home and finances. Misty's a big fan of faith, coffee, camping, dogs, books, & bargains!