Managing Your Money

How do health savings accounts (HSA) work?

My employer recently started offering Health Savings Accounts. I’m not sure what they are and how they work. Can you explain?

A health savings account (HSA) is a tax-advantaged alternative to traditional health insurance. HSAs work in conjunction with high-deductible health plans (HDHP). A high deductible health plan is a health insurance plan that typically has lower premiums but higher deductibles. HDHPs typically cover 100% of the insured’s medical expenses once the total out-of-pocket limits are met (including the deductible). For 2011, the annual out-of-pocket expense limit cannot exceed $5,950 for individual coverage and $11,900 for family coverage. The minimum deductible for a HDHP (for 2011) is $1,200 for individual coverage and $2,400 for family coverage.

As mentioned earlier, HSAs work in conjunction with HDHPs. Therefore, you need to enroll in an HDHP before you are eligible to establish an HSA. Once you establish an HSA, it can provide you with significant benefits including the following:

• You can make contributions (pre-tax and after-tax) to your HSA. Pre-tax contributions can reduce your taxable income and after-tax contributions are deductible.
• Contributions to your HSA as well as any earnings on those contributions grow tax deferred.
• Contributions to your HSA for 2011 are limited to $3,050 for individuals and $6,150 for families. However, if you are 55 or older you may be qualified to make additional catch-up contributions.
• Withdrawals from your HSA that are used for qualified medical expenses are tax-free. In addition, withdrawals can also be used for you deductible and co-pays.
• In certain cases, withdrawals may be used to pay for long-term care or disability insurance premiums.
• Unlike flexible spending accounts, there is no “use-it-or-lose-it” provision on unused HSA funds at the end of each year.
• Contributions and earnings that you withdraw will be tax free if they are used to pay for qualified medical expenses.
• HSAs are portable. Therefore, you can take it with you if you change employers.
• Your employer can make contributions to your HSA on your behalf.
• HSAs typically offer various savings and investment options (e.g., checking account, savings accounts, money market accounts, stocks, bonds, and mutual funds).

The benefits mentioned above are powerful ways to save, however, there are some disadvantages and limitations of HSAs that are important to know. These disadvantages include the following:

• If you are under the age of 65 and you use your HSA funds for non-qualified medical expenses, you will need to pay a 20% penalty (for 2011) plus income taxes on those withdrawals. If you are 65 or older the penalty does not apply, however, you will still need to pay income taxes on withdrawals for non-qualified medical expenses.
• You may not be able open an HSA if you are covered by another health insurance plan.
• You cannot open an HSA if you are 65 or older and you are enrolled in Medicare. This is also true if you are 65 or older and you are claimed as someone else’s dependent.
• If you invest the money in your HSA in stocks, bonds, or mutual funds those funds are subject to market fluctuations and may decline in value over time. This may result in the loss of principal in you HSA.

Starting an HSA generally makes more sense for those with lower medical expenses who have the ability to grow their savings over time. For those with higher medical expenses, you may end up depleting most if not all of the funds in your HSA before you’ve had a chance to build up any savings.

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