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  • Writer's pictureAsad Gourani, CFP®

Understanding Health Saving Accounts

Updated: Jan 18, 2021

How Health Saving Accounts Work

Do you have a plan for unexpected medical bills? Many people hesitate when asked how they would come up with the funds to cover an unexpected illness or hospitalization. This does not bode well for the future, as most people will have an unexpected ailment at some point. However, there is something that you can do to better prepare yourself for the inevitable.

A Health Savings Account or an HSA is a tax-sheltered account that can be used to pay for your medical purposes using pre-tax money. Even better, the money that you spend on qualified medical expenses will also be tax-free! Here’s what you should know:

The Basics

In order to qualify for an HSA, you must have a high deductible health insurance plan. This means that you must have a deductible of at least $1,400 for an individual or $2,800 for a family. Each year, you can contribute up to $3,550 for individual coverage into an HSA or $7,100 for a family.

Why is this a wise use of your hard-earned dollars? First and foremost, you are contributing to your health savings account using pre-tax money that remains untaxed if used to cover qualified medical expenses. In the meantime, you can invest it in any way you want and allow it to grow tax-sheltered. The money you invest here is considered tax-deductible, meaning that you don’t pay taxes on the amount contributed.

Unlike a Flexible Spending Account (FSA), the money deposited in your HSA does not expire and it is yours to keep. There is no “use it or lose it” policy that threatens to take away the money you have contributed. However, there is one caveat to this type of account: you must use it on qualified medical expenses or you will owe income tax on the amount withdrawn since the money was not taxed to begin with.

If you do not spend the money on medical expenses and are under the age of 65, you will also owe an additional twenty percent penalty. Individuals over the age of 65 can spend the money on anything and everything and are subject only to income tax (Think of the tax consequences above the age of 65 as similar to having an IRA).

Fortunately, you will find that the definition of qualified medical expenses is quite broad. It can even be used to cover some expenses not covered by insurance such as dental and vision. It can even be used to cover medical expenses for a spouse or dependents. For those who are over the age of 65, it can also be used to cover the cost of Medicare premiums.

The Power of an HSA

To better understand the power of a health savings account, let’s take a look at a small scenario. Assume that you are in the 25 percent tax bracket with a high deductible health plan. You suffer from an accident that results in $750 worth of medical expenses. Without a health savings account, you would have to earn roughly $1,000 in pre-tax income to cover the cost of those medical bills.

With an HSA, you only need to earn $750 because the money contributed is pre-tax money that is not getting taxed, even during withdrawals (provided that these withdrawals are for qualified medical expenses like this one).

Not only does an HSA allow your money to grow, but it also helps you to prepare for the future. Everyone will eventually face some type of medical expense. By setting aside money here and now to pay for those bills, you can rest easy when the time comes. It is a powerful financial tool that you should have in your arsenal if you have a high deductible health plan.



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