Understanding Health Savings Accounts

By Jeffrey W. Hunter, Vice President, Wealth Strategist

Growing old can really be expensive! A major reason for this is the rising costs of health care.

A tax-advantaged savings tool known as a Health Savings Account (HSA) can assist you with managing healthcare costs now and in retirement. The potential benefits offered by HSAs may be substantial under the right circumstances.

Even though HSAs have been around for more than 20 years, there still seems to be a great deal of confusion about how they work. Hopefully, this article will help clear-up some of the confusion and provide you with a solid understanding of the key attributes, as well as some limitations, of HSAs.

HSA in a nutshell
An HSA is a tax-advantaged account that may be available to you if you are enrolled in a high-deductible health insurance plan. The account is specifically designed to help people save money for their current and future medical expenses in a tax-free manner.

Eligibility
To save money in an HSA, you must first be enrolled in a high-deductible health insurance plan (HDHP). These HSA-eligible health plans must meet or exceed certain deductible limits set by the IRS each year. For 2025, a HDHP must have a minimum annual deductible of $1,650 for self-only coverage or $3,300 for family coverage. Your annual deductible is the amount that you must pay out-of-pocket for any covered medical expenses before your insurance kicks-in and begins paying for anything.

While HDHPs have higher deductibles than most HMOs or PPOs, they do come with an out-of-pocket maximum. That is the most that you will pay for any medical expenses before your insurance picks up 100% of the rest. The IRS also sets annual limits on your maximum out-of-pocket expenses for a HDHP to be considered HSA-compatible. For 2025, that annual out of-pocket limit is $8,300 for an individual plan or $16,600 in you have family coverage.

Assuming you are already enrolled in a HDHP that is HSA-eligible, you still need to meet a few additional requirements before you can open or contribute to an HSA. In this regard, you must also:

1. Not be covered by any other health insurance plan that provides the same benefits already covered by your HDHP.
2. Be 18 years of age or older.
3. Not be claimed as a dependent on someone else's tax return; and
4. Not be enrolled in any part of Medicare.

Tax benefits
HSAs are tax advantaged accounts as explained below.

The first tax break comes with your annual contributions. HSA contributions are either pre-tax (if made via payroll deductions) or tax deductible (if you make your own contributions). This not only saves you taxes in the year of the contribution, but it also reduces your adjusted gross income, potentially making you eligible for certain other tax perks like the ability to contribute to a Roth IRA. The higher your current marginal tax bracket, the more money you will save.

The next break relates to the growth of your account. All earnings and growth are 100% tax deferred, meaning that your funds will grow without being subject to taxes.

Finally, any withdrawals from your HSA are 100% tax-free if used to pay for qualifying medical expenses.

There's one additional tax break, but only if you make your contributions via payroll deductions through your employer. In that case, your contribution will not only escape income taxes, but your employer will also not deduct any payroll taxes from your contributions as well. This will save you another 6.2% in Social Security taxes and 1.45% in Medicare taxes on any amount that you contribute.

Finally, unlike other types of tax advantaged accounts such as Roth or traditional IRAs, there are no annual income limits for HSAs. You can contribute to an HSA regardless of whether your annual income is $100 or $1,000,000.

Contribution limits
The IRS does place some limits on how much you can contribute to an HSA each year. These limits are adjusted each year based on inflation. The maximum amount that you can contribute each year is dependent on the type of coverage that you have under your HDHP. For 2025, individuals with self-only coverage can save up to $4,300 and those with family coverage can save up to $8,550.

Once an HSA account owner reaches age 55, they can also contribute an additional $1,000/year to their account as a catch-up contribution.

One thing to be aware of is that the IRS treats married couples as a single tax unit. This means that both spouses share one combined family HSA contribution limit. So, even if each spouse has their own HDHP and HSA, they cannot save more than the amount of the HSA family coverage limit for that year in their combined accounts ($8,550 for 2025 plus any age 55 catch-up contributions).

Some employers also make annual contributions to the HSA accounts of their employees. If you're the lucky recipient of any such employer contributions, please know that those contributions will also count towards your maximum contribution limits for the year.

Withdrawal rules
As mentioned above, you can receive a tax-free distribution from your HSA to pay for any qualifying medical expenses. This includes any medical expenses for you, your spouse, or any dependents that you claim on your tax return.

If you are under the age of 65 and you use your HSA funds to pay for anything other than a qualified medical expense, you will pay taxes on the withdrawal plus a 20% penalty.

However, after reaching age 65, you can take penalty-free distributions from your HSA for any reason whatsoever. However, to be both tax-free and penalty-free, the distribution must be for a qualified medical expense. Withdrawals made for any other purpose will be subject to income taxes but will avoid the 20% penalty that apply to withdrawals when you are under the age of 65. So, upon reaching age 65, your HSA functions similarly to a traditional IRA or 401(k) plan. The one exception being that any distributions from your HSA to pay for qualifying medical expenses will always be tax-free.

Qualified medical expenses
Qualified medical expenses include any expenses that would generally qualify for the medical and dental expenses deduction set forth in IRS Publication 502. The list of IRS-approved expenses is extremely broad and includes expenses related to medical, dental, and vision care. Here's a brief list of some of the more common HSA-eligible expenses:

• All copays, deductibles, or coinsurance for your medical, dental or vision expenses
• Prescription drugs and over-the counter medications
• Eye exams, eyeglasses, contact lenses and Lasik surgery
• Vaccines and flu shots
• Doctor's office visits, blood tests, and x-rays
• Dentures, dental surgery, crowns, bridges and orthodontia
• Physical therapy
• Surgery (excluding cosmetic surgery)
• Hearing aids and batteries
• Chiropractic care and acupuncture

Most health insurance premiums are not considered qualified medical expenses. However, there are a few notable exceptions. In this regard, premiums for the following items will qualify as a qualified medical expense:

• Long -term care insurance (subject to limits based on age)
• COBRA coverage
• Health care coverage while you are receiving unemployment compensation
• Certain Medicare expenses, including your Part B, Part D and Medicare Advantage plan premiums (but not you supplemental "Medigap" premiums)

Versus a Flexible Spending Account (FSA)
An HSA and a Flexible Spending Account (FSA) are somewhat similar in that both types of accounts allow you to make pre-tax contributions and spend the money tax-free on qualified medical expenses. However, there are some notable differences between the two types of accounts. You cannot contribute to both, so let's review some of these differences.

One difference between the two accounts is that an HSA requires enrollment in an IRS-qualified HDHP. By contrast, virtually any health plan is compatible with an FSA.

With an FSA, you elect at the beginning of the plan year (i.e., during your open enrollment period) the total amount that you want to set aside to pay any qualified health care expenses for the upcoming year. These funds are then saved and spent on a year-by-year basis. That is why an FSA is known as a "use it or lose it" type of account. Any funds that are not spent by the end of the plan year get forfeited back to your employer.

With an HSA, you own the account, and your funds never expire even if you change employers, change your health plan, or retire. An HSA is not a "use it or lose it" type of account. Any unspent funds will remain in your account year after year and into your retirement.

HSAs offer the unique opportunity to invest the funds in your account and any potential growth accrues on a tax-deferred basis. You are not able to invest your FSA funds, so whatever money you elect to contribute for the year is all that you'll get.

You also have an unlimited amount of time to reimburse yourself with an HSA. For example, let's say that you incurred a $1,000 qualifying medical expense in 2025. With an HSA, you have the option of being reimbursed now from your account or you can decide to pay the expense out of pocket and seek reimbursement at some time in the future. Regardless of when you decide to be reimbursed, the withdrawal from your HSA will be tax-free since it represents a reimbursement for a qualified medical expense. While this may require some effort on your part to maintain good records and copies of receipts, this extra work affords you the incredible opportunity to tap into your HSA in the future and pay for things other than qualified medical expenses on a tax-free basis (to the extent you paid out-of-pocket for prior eligible medical expenses). In contrast, with FSAs you must submit receipts by the deadline set by your employer for each individual plan year.

Finally, annual contribution limits are lower for FSAs as opposed to HSAs. In this regard, the maximum annual contribution to an FSA in 2025 is $3,300 regardless of the type of health plan that you have.

Death of account holder
Upon the death of an HSA account holder, any amounts remaining in the HSA transfer to the beneficiary named on the HSA beneficiary designation form. If your spouse is the beneficiary, your HSA will transfer to your spouse, and they now own the account. This provides them with all the benefits of account ownership, and they can continue making tax-free withdrawals from the HSA to pay for any of their current or future health care expenses.

You can also name your children or another non-spouse individual as a beneficiary. However, the tax benefits of the account will not transfer over to a non-spouse beneficiary. Instead, the balance in the account will be distributed to the beneficiary and the entire amount of the HSA will be included in the beneficiary's taxable income in the year of the original account owner's death (less the amount of any medical expenses incurred prior to the account owner's death that are paid from the HSA within one year after their death).

Naming a charity as the beneficiary of your HSA is another option. In that case, the charity can receive the funds and avoid any income taxes.

Finally, if you do not name a beneficiary for your account, your estate becomes the beneficiary of your HSA. In that case, your HSA assets will pass to your estate and be included as taxable income on your final income tax return.

Choosing the right insurance coverage
As explained above, to realize the benefits of an HSA, you must first be enrolled in a HDHP. This is what makes you eligible to contribute to an HSA. Accordingly, before signing up for an HSA, you first need to determine whether a HDHP makes sense for you and your family. To that end, let's begin by reviewing some of the pros and cons of HDHPs.

One of the big advantages of a HDHP is that they often have much lower premiums compared to similar plans with a lower deductible. If you and your family are in good health and don't anticipate much in the way of medical expenses, a HDHP could save you hundreds of dollars each year in the form of reduced premium payments.

Many times, HDHPs will also cover certain preventative procedures and tests without regard to your deductible and at little or no out-of-pocket costs to you. This can include things like annual physicals, immunizations, routine prenatal and postnatal care, and certain health screenings.

Another advantage to a HDHP is that it makes you eligible for an HSA. This, as we now know, provides you the opportunity save pre-tax dollars that you can use for your current or future medical expenses.

Finally, many employer's offering HSAs also make annual contributions to the accounts of their employees. This is essentially free money that you can apply towards the costs of any of your current or future health care expenses.

Now let's turn our focus to some of the disadvantages of HDHPs. By far, the biggest drawback to a HDHP is the potential for higher out-of-pocket medical expenses if you or a member of your family requires extensive medical treatments or care. In that case, you could be responsible for all these costs up to the amount of your deductible plus any copays and co-insurance up until you reach your out-of-pocket maximum.

Another potential disadvantage is that you may decide to put off certain doctor visits and medical procedures due to the higher out-of-pocket costs associated with a HDHP. Over time, this may lead to more serious health issues and even higher future medical bills.

So, while a HDHP together with an HSA may be the right choice for many, it's not the best choice for everyone. Here are a few additional considerations to help guide your decisions.

A HDHP and an HSA may make sense for you if:

• You and your family are healthy and rarely require medical care for an illness or injury
• You can afford to pay your deductible upfront if a medical need arises
• You can make significant contributions to your HSA and intend to save and invest that money rather than use it to meet your current expenses
• Your employer contributes money to your HSA account each year to cover some or most of your deductible

Alternatively, a HDHP may not make sense for you if:

• You can't afford the high deductible
• You or a member of your family have a chronic condition that requires ongoing treatments, care and medications
• You or a member of your family participate in a high-risk sport or hobby
• You are pregnant, planning to be pregnant, or have young children

Your HSA and investing
We've gone over some of the key attributes and limitations of HSAs. Another benefit of HSAs is that you can invest HSA funds that you are not using to cover eligible medical expenses.

Many HSA owners never invest the funds in their HSA and choose to remain in cash. By strategically saving and investing your HSA funds for retirement rather than spending them on your immediate healthcare expenses, you could maximize your HSA's potential for tax-free long-term growth. The HSA funds can then be accessed tax-free in retirement to pay for any future qualified medical expenses and to reimburse you for any qualified medical expenses that you previously paid out-of-pocket. In addition, after reaching age 65, you can then access these funds on a taxable basis for any reason without a penalty just like a traditional IRA.

Conclusion
This article's goal is to increase your knowledge and understanding of the HSA. For more information about your specific health insurance and tax requirements, please speak to your personal tax advisor and financial advisor.

TD Wealth® does not provide tax, legal or accounting advice.