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HSA 101—What Is a Health Savings Account and How Does It Work?

how does health savings account work

By Elizabeth Davis, RN. Health Insurance Expert

Updated June 29, 2015.

What Is an HSA?

An HSA, or Health Savings Account, is a special type of tax-advantaged savings account designed to help you pay for out-of-pocket medical expenses when you have a high deductible health plan, or HDHP. In addition to being a smart way to pay for medical expenses like your deductible. copays. and coinsurance. HSAs are increasingly being used as part of a retirement-planning strategy .

If you don’t follow the rules, you’ll lose the tax advantages and owe additional penalties.

How Does an HSA Lower My Taxes?

If you manage your HSA correctly and follow all of the IRS rules, your HSA money is:

  • Not taxed when you earn it and put it into the HSA.
  • Not taxed as it grows.
  • Not taxed when you take it out of the HSA.

Here’s how it works. The money you put into your HSA is tax deductible. If your employer contributes to your HSA, that money isn't counted as income so you're not paying taxes on it, either.

Interest and investment earnings in your HSA grow tax-deferred like they do in an IRA. Since you’re not paying income taxes each year on the interest, you keep more of that interest in the account, and the account grows more quickly.

If you take money out of your HSA to pay for qualified medical expenses, you don’t have to pay income taxes on it. However, if you take money out of your HSA but don’t use it for medical expenses, you’ll have to pay income taxes on it plus a 20% penalty.

After you turn 65 years old,

the rules are a little different.

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If you’re on Medicare. you can’t contribute to your HSA anymore. However, you can still use the money you’ve saved in your HSA. Unlike before you turned 65, you can spend your HSA money on anything you want and you won’t have the 20% penalty. However, you’ll have to pay income taxes on HSA withdrawals not used for medical expenses. If you take money out of your HSA and use it for qualified medical expenses, you don’t pay regular income taxes on it; it’s totally tax-free.

Who’s Eligible for an HSA?

You’re eligible to start and contribute to an HSA if you meet all of these requirements:

  1. You’re covered by a qualified HDHP.
  2. You don’t have additional, more traditional, health insurance coverage.
  3. You aren’t on Medicare.
  4. Nobody else can claim you as a dependent on their tax return.
  5. You don't have a general purpose Flexible Spending Account .

If you already have an HSA and you no longer meet all of the eligibility criteria, in most cases, you may still keep the HSA and use the money in it to pay for eligible medical expenses. However, you can’t contribute any more money into the HSA if you don’t meet all of the eligibility criteria listed above.

How Does Money Get Into the HSA?

You can contribute money into your HSA yourself, your employer may contribute money into your HSA, or another person may contribute money into your HSA. However, the total yearly contributions to your HSA are limited. The limits change each year and vary based on your age and whether you have self-only HDHP coverage or family coverage.

Category: Personal Finance

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