A health savings account (HSA) is a tax-sheltered account that allows tax-deductible contributions and tax-free distributions (when used correctly). To receive these tax benefits, you must meet specific eligibility rules.
To qualify to make contributions to an HSA, you must be covered by a high deductible health insurance plan. These plans typically have lower premiums but higher deductibles. You also can’t be covered by Medicare and can’t be claimed as a dependent on another person’s tax return. If you meet these requirements, you may contribute to an HSA. Contributions are deductible (often described as pre-tax), meaning the amount you contribute reduces your earned income for tax purposes, which can lower your income taxes.
After money is contributed, it can be invested in a wide variety of securities, including common stock, preferred stock, bonds, mutual funds, and exchange traded funds (ETFs). The assets grow on a tax-deferred basis, meaning investment gains generally aren’t taxed until money is distributed from the account.
The primary purpose of an HSA is to pay for medical expenses. When you have a qualified medical expense, you may withdraw money from your HSA to pay for it. If the distribution is used for qualified medical expenses, it isn’t subject to taxes.
If HSA money is used for non-qualified expenses, the distribution is subject to ordinary income taxes plus a 20% penalty.*
*Although lightly tested, there are two exceptions to the 20% penalty. This penalty does not apply when the account owner turns age 65 or qualifies as disabled (as per IRS requirements). Regardless, the IRS still considers the distribution to be taxable ordinary income.
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