What Is An HSA And How Does It Work

The most underutilized account that offers the most tax benefits

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Peter Campbell
September 22, 2022
What is an HSA

The Health Savings Account (HSA) is perhaps the most underutilized account type out there, even though it offers the highest number of tax benefits. No other account offers the triple tax benefits that an HSA can offer – tax deductions, tax-deferred growth, and tax-free withdrawals. Yet, most people don’t know about this account, let alone take advantage of them. We hope that we can help to change this, to some degree, by demystifying this account.

Health Savings Accounts are tax-advantaged health savings plans that can act as both a checking and investment account. You contribute money to an HSA and can then use the funds through a debit card to pay for medical expenses. The benefit to using an HSA instead of a regular bank account for your savings is that HSAs are the most tax-advantaged account that exists, with three key tax breaks:

  1. Tax deduction when you put money into an HSA.
  2. Tax-deferred growth on your investments within the HSA.
  3. Tax-free withdrawals when you take money out to pay for qualified medical expenses.

Think of HSAs if you were to combine the benefits of a Traditional IRA and a Roth IRA. You get to take a tax deduction when you contribute to your HSA. The money grows completely tax-free (no taxes on dividends or any appreciation). And when you use the funds to pay for qualified medical expenses, it is an entirely tax-free withdrawal. Unlike a traditional IRA account, there are no required distributions from an HSA, so the IRS can’t tell you when to take money out. Best of all, no income limitations restrict you from contributing.

It is the ultimate account, but like many things related to finance and taxes, HSAs can be confusing, which prevents people from opening the account or making the most of it. According to the Employee Benefit Research Institute, 78% of those eligible for an HSA don’t even open an account. Half of the 22% that open an HSA don’t contribute. If they do, they rarely invest the funds and take advantage of all the tax benefits.

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Who can open a Health Savings Account?

For those on Medicare, let me save you the time to read this article…there is no HSA-eligible plan through Medicare. If you are on Medicare and still have money in an HSA, you can use those funds to pay your Medicare premiums.

Two critical components to determining if you have an HSA-eligible health plan are your deductible and your out-of-pocket max.  People often mistake only looking at their deductible and assuming they qualify, forgetting to account for the second qualifier regarding the out-of-pocket maximum.

2022 health plan requirements for HSA eligibility

High Deductible Health Plan (HDHP)
Minimum deductible required on your health plan  
Self-only: $1,400
Family: $2,800
HDHP maximum out-of-pocket (deductibles,
co-payments and other amounts, but not premiums)
Self-only: $7,050
Family: $14,100

To qualify for a Health Savings Account, your health plan must have those two factors above.  It must be eligible as a high deductible health plan with a deductible of at least $1,400 self-only or $2,800 as a family, and you must have an out-of-pocket max of no more than the above numbers.  Due note that the out-of-pocket number is the max, not the minimum.  This is where many people go wrong with thinking they qualify for an HSA.  For a family in 2022, you need to have a minimum deductible of $2,800, and your maximum out-of-pocket needs to be $14,100 or less.

How much can you contribute to a Health Savings Account?

The amount you can contribute is based on the calendar year. If you had an eligible health plan for only part of the year, your contribution would be prorated.  You also are eligible to contribute to an HSA plan anytime during the calendar year or even before the tax filing deadline for that year’s tax return.  For the calendar year 2022, you have until the federal tax return deadline of April 15th, 2023, to fund your HSA.

2022 HSA contribution limits

 Self-onlyFamily
HSA contribution limit  $3,650$7,300
HSA catch-up (additional contributions for those ages 55+)$1,000$1,000

Often your employer may provide an HSA-eligible plan and even contribute on your behalf, similar to a 401(k) match.  While there are three significant tax advantages to an HSA, an employer-provided plan has a fourth extra benefit.  If you contribute to an employer-sponsored HSA plan through payroll deductions, your contributions will get to avoid payroll taxes.  This can bring the Health Savings Account into the rarified air of being quadruple tax-advantaged!  If you participate in an HSA plan your work offers, be aware that employer contributions count towards the maximum limit.

Should you choose a High Deductible Health Plan?

Like many financial choices, that is a personal decision.  While an HDHP can make people nervous about having to pay more for medical care due to a higher deductible, they also have the benefit of having lower monthly premiums. They can invest that extra cash flow into an HSA.  Nobody can predict their medical future, but our health coverage is temporary and can be adjusted next year or after a qualifying event. People often know when an expected life event or surgery is approaching, giving them the option to be intentional when choosing their health plan for the following year.

What happens if you withdraw HSA funds for unqualified expenses?

You will pay a 20% penalty on the amount you withdraw and ordinary income tax on the withdrawal if the funds are not used for a qualified medical expense.  On a positive note, if you are 65 or older, you can withdraw HSA funds for any reason without paying the penalty. The withdrawal will still be taxed as ordinary income, but the penalty is waived.  Because of this feature, beyond age 65, many people view HSA funds as another potential retirement savings vehicle.  It certainly is; however, the best usage of an HSA is to optimize it and achieve triple tax benefits.

How to make the most of an HSA?

When opening a Health Savings Account, you can choose to leave the funds as cash, making the HSA function as a checking account.  Or you can choose to invest the funds within the HSA. Investing allows for the most significant growth potential for those looking to build a large HSA for long-term goals.  Investing the funds is also the best way to take advantage of all the tax benefits the account provides.

Ideally, you would treat the account more as a long-term investment account. Continue to contribute to and build up your HSA, but don’t just leave the funds in cash; invest them. This allows your money to grow, compound over time, and maximize the tax benefits. Most HSAs require the first $1,000 to remain as cash, but money can be invested above that amount. Usually, the accounts offer a lineup of simple, low-cost index funds.

The real strategy comes when you have a medical expense. Don’t use money from your HSA.  Pay from your cash flow or checking account and keep and store your receipts for the medical costs.  Finding a digital solution to store your receipts is a good idea for longevity.  Money in an HSA rolls over year after year. It is not a use it or lose it account like an FSA.

Paying with cash allows the HSA to continue to grow tax-deferred.  Eventually, when you want to access the funds, such as to create retirement income, you can withdraw the funds and treat it as if you are paying yourself back for the previous medical expenses.  The result is that the withdrawal is tax-free since it is technically a reimbursement to yourself from years ago.   

What can you use an HSA for?

The IRS defines medical care expenses as “payments for the diagnosis, cure, mitigation, treatment, or prevention of disease, or payments for treatments affecting any structure or function of the body.”

Outside of medical care, there are many routine products people don’t realize are qualified HSA expenses. Band-Aids, therapeutic massages, prescription sunglasses, sunscreen, vitamins, dentures, crutches, and more.  Amazon now has a filter allowing you to search for only HSA-eligible items.

You can even use your HSA when traveling internationally to pay for treatment in a foreign country. The funds can also be used for any prescription drugs you purchase and consume in that country. When traveling, you can even include the costs for transportation and lodging if the trip is essential to receiving medical treatment.

HSA contributions are taxable in California and New Jersey

For those in California and New Jersey, know that your state income taxes ignore your HSA contributions. They treat it as if you never contributed, so there is no income tax deduction related to HSAs on the state level in those two states.

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