Health Savings Account 101: How Does an HSA Work?

Katie McBeth
How HSAs Work

Health insurance in the United States is a complicated beast. There are many variables that go into each plan, each network, and each individual’s coverage. How do you determine which plan works best for you? How can you decipher the plan to better understand the coverage it provides? Where do you even buy health insurance?

Health savings accounts (HSA) are one type of health care plan that might be right for you, but first, you need to understand what an HSA entails. There are a lot of rules and regulations that go into an HSA plan, but it could be the perfect plan for you and your family.

Table of Contents

What Is a Health Savings Account (HSA)?

Health Savings Accounts (HSA) are essentially just what the name entails: a savings account you open via a bank that functions similarly to a checking account and is used strictly for healthcare and medical expenses.

This allows you to contribute untaxed money directly from your paycheck that you can either save up for future medical expenses or even use to invest in stocks or bonds (similar to an individual retirement account). The whole purpose of an HSA is to help you save up for any future medical expenses, ensuring that down the road you’ll be covered if you have a massive medical bill.

However, an HSA can also grow through investments. Once you open an HSA account with a bank that either your sponsoring employer or insurance provider chooses, the bank will have varying options on what you can invest in if you so desire.

Also similar to an IRA, the contributions that are made to your HSA are taken directly from your paycheck and there’s a yearly maximum limit for contributions (determined by the IRS). As of January 2020, the  maximum HSA contribution limit is $3,550 for individuals, $7,100 for families, and $1,000 for policyholders over 55. Some employers also offer to make contributions on your behalf, which can save you money.

Additionally, there is no end-term to your HSA, meaning the money you contribute will roll over every year. You’ll never lose what you contribute to the account, even if your plan ends or your employer changes insurance providers.

HSAs are beneficial for people who don’t have a lot of yearly medical expenses and are relatively healthy. They also offer additional benefits, such as tax-free withdrawing, and can work as an additional retirement account for those over the age of 65.

Tax Benefits of an HSA

The contributions you make to an HSA are also pre-tax, which means you don’t have to pay taxes on the amount going in, and — as long as what you are paying for is a qualified medical service — you don’t have to pay any taxes on what you withdraw.

Additionally, whatever you save up in your HSA account can be used to reduce what you owe in taxes at the end of the year or when you file taxes. The after-tax dollars you’ve saved up in the account can be deducted from your gross income, allowing you to save a bit during tax season.

If you do withdraw money from your HSA for non-medical expenses prior to turning 65, you will be required to pay taxes on the amount as well as a 20% penalty fee for withdrawing. After you turn 65, however, withdrawals will not be subject to taxes or the penalty fee, which means HSAs can be used as a small alternative retirement account.

These are some of the greatest benefits to the HSA, but why do HSAs exist in the first place?

High-Deductible Health Plans (HDHP)

One of the main reasons why HSAs have grown in popularity over the past few years is the high-deductible health plans (HDHP). High deductible refers to the total dollar amount an insurance plan may require a patient to pay out of pocket before their coverage plan kicks in and makes payments for claims. For an HDHP, this deductible is higher than most other plans, meaning you will pay more out of pocket if you have a chronic illness or have multiple accidents out of the year.

These plans are often coupled with HSAs to help you save up for any potential health needs you might have in the future. Traditionally, those that sign up for an HDHP won’t be visiting the doctor on a regular basis, so you can have more time saving up via your HSA, and will hopefully have enough to cover any emergency expenses that might arise down the road.

However, HDHPs and the HSAs that come with them are not right for everyone. What disadvantages do these plans have, and what else do you need to know?

Disadvantages of HSAs

Unfortunately, having an HSA plan can be a bit of a gamble with your finances. You never know when you’ll fall into a medical emergency, and your HSA might only cover a fraction of the cost. This is one of the biggest disadvantages of these plans: the risk of potential medical debt.

Luckily, the government tries to curb some of the debt by creating mandatory limits on out-of-pocket expenses for insured patients with HDHPs. These out-of-pocket limits are set to increase in 2021 to $8,550 for individuals and $17,100 for families. Any medical expenses that exceed that amount within a year must be covered in full by the insurance provider.

However, that still leaves an average gap of about $5,000 for individuals and $10,000 for families between what an HSA can cover and what your insurance will cover within the year. That’s enough of a gap to put many average Americans into a bit of a financial hole and could lead to outstanding medical bills. So, although you may be saving money and paying less per month on health insurance by opting for an HSA, there are certainly plenty of financial risks that can come with these plans.

What Can’t You Use Your HSA For?

There are hundreds of procedures that are covered by HSAs, and all of them can be found on the IRS’s website. However, not all medical or medically related services are covered by an HSA. This means if you use your HSA for an unqualified service, you could be subject to additional fees and penalties.

Some of the services that are not covered by an HSA include:

  • Daycare, babysitting, or child nursing services (for a normal healthy baby);
  • Cosmetic services;
  • Hair transplants;
  • Funeral services;
  • Nonprescription drugs or medications;
  • Items for personal use;
  • Insurance premiums (the monthly fee you pay to have insurance);
  • Veterinary fees for pets;
  • Weight loss programs.

All of the procedures and items that are not covered by traditional HSAs can be found on the IRS’s Publication 502, Medical and Dental Expenses page. The IRS provides a list every year for the tax season, so be sure to find the latest version prior to filing your yearly tax return.

How to Get an HSA

The only way you can qualify for an HSA is if you are signed up with an HDHP, whether through your employer or through your local health insurance exchange ( These HDHPs will most likely have lower monthly premiums than other options, and some will include HSA in the description.

When you sign up for an HDHP, you will sometimes be given the option to open an HSA with the bank of your choosing. Other times — such as when your employer has a contract with the insurance provider or the provider has a contract with a banking institution — the HSA will be opened for you by the provider at a bank of their choosing.

If you are given the freedom to choose the bank for your HSA, many banks, including local credit unions, will be able to help you open an account. Simply search for local HSA providers online to see your options.

How to Use an HSA

Once you’ve decided on an HDHP and HSA that works for you and your family, all you’ll need to do is follow through the signup procedure. If you are signing up through your employer, most of the work will be done for you. If you’re signing up through the government, you might have a couple of extra steps you will need to complete.

In the end, you should have an insurance provider, a bank that provides the HSA as well as a card to access it; a portion of your employer paycheck will automatically go into the HSA every month.

When it comes to paying your medical bills with your HSA funds it’s as simple as running a debit card. When signing up, you will often create a personal identification number (PIN) that you can use to verify any purchases or medical expenses. Be sure to keep all your receipts just in case you are audited by the IRS. Traditionally, the IRS recommends keeping records for three to seven years after the fact.

HSAs will continue to accrue until your plan is canceled or you decide to change your coverage. However, money will never be lost. You will always be able to use some of those funds to help pay for little expenses; at least until all those funds are gone. It is also important to note that the IRS forbids individuals from combining HSAs or rolling them over into other savings accounts. If you have multiple HSAs, speak with your bank about options for consolidating accounts.

Finding the Right Healthcare Plan for You

The health insurance market is a frightening maze of uncertainty and is in constant flux. With the constant potential for policy changes and insurance premium increases, it can be far too easy to be overwhelmed when you try to dive into the specifics of your plan.

If you’re wondering if an HSA plan is right for you, consider your current health, your family’s health, and what level of medical care you hope to get in the next year. Choosing an HSA plan might be the right move for you, but it’s important to know about all the potential risks and challenges of signing up for this type of high-deductible plan.

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